ON.RRP Operations as a Monetary Policy Tool: Design Considerations

1. “ON RRP Operations as a Monetary Policy Tool:Some Design Considerations”by Josh Frost, Lorie Logan, Antoine Martin, Patrick McCabe, Fabio Natalucci, and Julie RamachePresentation at the 3rd NYU Economics PhD AlumniConferenceMay 29-30, 2015 The views expressed here are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or its staff.

2. Overview of the Paper • Review recent changes in monetary policy that have led to the development and testing of an ON RRP facility • “A Federal Reserve facility that conducts overnight (ON) reverse repurchase agreements (RRPs) with eligible counterparties. An RRP is an open market operation (OMO) in which the FRBNY Desk sells a security to the counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The transaction is economically similar to the counterparty lending to the Fed, with the security serving as collateral for the loan. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the cash invested by the RRP counterparty.” • Explain usefulness of ON RRPs for implementing monetary policy during normalization • Examine secondary effects of an ON RRP facility • Federal Reserve footprint in short-term funding markets • Financial stability implications (positive and negative) • Investigate design features of an ON RRP facility that could mitigate undesirable secondary effects • Discuss tradeoffs policymakers face in designing an ON RRP facility • Balance objectives of setting effective floor on money markets during normalization and limiting adverse secondary effects 1

3. Operating Framework before the Financial Crisis • Before the financial crisis, the FOMC conducted monetary policy by setting a target for ON FFR • The Desk transacted with PDs to adjust the supply of reserves so that, for a given level of demand, market-clearing FFR would be consistent with the target • “Corridor” operating framework • The Desk made outright purchases of Treasury securities and conducted temporary, fine-tuning operations in the form of RPs and RRPs in markets for gov’t securities • The Desk maintained a “structural deficiency” in reserves, so fine-tuning operations were primarily RPs that temporarily boosted reserves 2

4. Federal Reserve Response to the Crisis • The Federal Reserve responses to the financial crisis included important changes to the conduct of monetary policy • Reduction of FFR from 5 ¼ to a target range of zero to ¼ • Introduction of a number of facilities to provide liquidity to financial institutions in order to maintain the flow of credit and improve financial market conditions • Asset purchases to put downward pressure on long-term rates • Forward guidance regarding the path of FFR 3

5. Federal Reserve Balance Sheet 4

6. Introduction of Interest on Excess Reserves • Starting in October 2008, the Federal Reserve has been authorized to pay interest on reserves held by DIs • In the current environment in which the supply of reserves far exceeds the amount needed for reserve requirements, IOER has become the primary tool of monetary policy • “Floor” operating system • IOER is not available to MMFs, other cash-management vehicles, nonfinancial corporations, and GSEs • In the absence of frictions, competitions should push money market rates close to IOER • In practice, arbitrage across money market rates is not costless • Balance sheet costs related to FDIC assessment fee, Basel III leverage ratio • These costs drive a wedge between IOER and other money market rates 5

7. Selected Money Market Rates • IOER alone does not set a firm floor under money market rates 6

8. ON RRP as a Complement to IOER • One way to strengthen the floor on short-term interest rates is to offer an ON, risk-free instrument to a wider range of market participants • An RRP is economically equivalent to a loan to the Federal Reserve collateralized by securities in the SOMA portfolio • The ON RRP rate is a risk-free rate set by the Federal Reserve available to nonbank investors active in money markets • Currently 163 RRP counterparties, including PDs (22), banks (24), GSEs (12) and MMFs (105) • Access to ON RRPs should increase competitiveness in money markets and strengthen effectiveness of floor on short-term rates • The option to invest in ON RRPs should provide bargaining power to investors with access to the ON RRP rate in their negotiations with borrowers in money markets 7

9. “Policy Normalization Principles and Plans” • When economic conditions and the economic outlook warrant a less accommodative monetary policy, the Committee will raise its target range for the federal funds rate. • During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances. • During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. The Committee will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate. 8

10. ON RRP Testing • Testing to date suggests that the ON RRP exercise has helped control short-term rates 9

11. ON RRP Testing (cont’d) • ON RRP take-up to date and caps 10

12. ON RRP Testing (cont’d) • ON RRP take-up increases when the spread between market rates and ON RRP rate narrows 11

13. Some Potential Secondary Effects • An ON RRP facility offered in full allotment, or even in very large amounts, could have significant secondary effects • Footprint: Expansion of Federal Reserve intermediation in short-term funding markets (particularly if the facility were permanent) could alter financial intermediation in unpredictable ways • Increased ON RRP take-up does not expand Federal Reserve balance sheet, it shifts the composition of the liabilities from reserves to RRPs • Financial stability implications • Beneficial effects: The public provision of a safe, short-term asset could displace seemingly safe, seemingly liquid private assets prone to run • Negative effects: A facility that allows for a very rapid expansion of ON RRPs might exacerbate disruptive FTQ flows during period of financial stress and thus undermine financial stability 12

14. Footprint Considerations • An ON RRP facility could expand the Federal Reserve role in financial markets by offering investors a new tool to manage liquidity and thus crowd out some private financing • Extent of crowding out would largely depend on the elasticity of demand of private financing • Permanently expanded role for the Federal Reserve in short-term funding markets could reshape the financial industry in ways difficult to anticipate and that may prove undesirable • Could lead to atrophy of private infrastructures 13

15. Footprint Considerations (cont’d) • ON RRPs may have served as a substitute for some private financing, although decline may also have reflected other unrelated factors 14

16. Financial Stability Considerations • Two distinct channels through which an ON RRP facility could affect financial stability • First, availability of an elastically supplied risk-free asset could influence the likelihood that money market investors would rapidly shift from providing private short-term funding to holding only very safe assets • Second, an ON RRP facility could affect the dynamics and severity of a run once a run is underway 15

17. Effects on the Dynamics and Severity of a Run • Absent an ON RRP facility, in the event of a run from private short-term funding markets, the supply of safe assets (such as Treasury securities) would not expand automatically to accommodate greater demand • Prices of safe assets would rise, making the run more costly • An ON RRP facility that elastically supplies a very safe asset provides no mechanism to slow the run • Although it could diminish the incentive to front-run other investors seeking to buy Treasuries or invest in gov’t-only MMFs 17

18. Flight-to-Quality Flows in 2008 • In the week of September 15-19, 2008, when the Lehman bankruptcy caused losses at prime MMFs and the Reserve Fund “broke the buck,” a variety of safe havens attracted inflows as investors ran from every short-term vehicle that embedded liquidity and credit risk 18

19. How Could a Large ON RRP Facility Alter FTQ Flows? • Flight-to-quality flows witnessed in previous stress episodes can provide a benchmark for the scale of flows that might be redirected to an ON RRP facility • But there could be additional safe-haven flows because of the existence of a new risk-free asset like ON RRPs • Greater within portfolio shifts to safe assets by MMFs that are ON RRP counterparties • Larger redemptions from prime MMFs and inflows into gov’t MMFs that hold ON RRPs • Larger inflows into these gov’t MMFs from other sources • The ultimate effect on financial stability and economic activity would depend on the nature of the institutions and firms that might lose short-term funding if investors shifts to ON RRPs 19

20. ON RRP Facility Design • A number of possible design features and safeguards for an ON RRP facility could limit the role of the Federal Reserve in financial intermediation and constrain sudden, sharp increases in take-up that might threaten financial stability • Making an ON RRP facility temporary • Changes in the ON RRP rate • Quantity controls • Combinations of rate and quantity controls 20

21. Setting a Cap on ON RRP Facility Size • Individual caps vs an aggregate cap • If counterparties’ demand for ON RRP is not perfectly correlated, an aggregate cap allows for more favorable tradeoff between limiting facility size and potential surges and avoiding frequent binding instances in normal market conditions • An auction provides a market-based mechanism to allocate usage • Single-price auction used in the current exercise if $300 billion cap is binding • Static vs dynamic, circuit-breaker cap • Circuit-breaker cap can be used to control potential one-day surges in ON RRP usage • It adjusts automatically to accommodate changing demand and market conditions, keeping the size of potential jumps in usage within a narrow range • Example: Dynamic cap set as ON RRP usage over previous 5 days plus $100 billion 21

22. ON RRP Take-up and Static and Dynamic Caps 22

23. Tradeoffs in Design of ON RRP Facility • Policymakers may face tradeoffs in designing an ON RRP facility as they seek to balance potentially competing objectives: • Setting an effective floor on money market rates • Minimizing the unintended consequences of a large footprint in short-term funding markets • Limiting risks to financial stability • These tradeoffs are likely to evolve over time • Implementation of new capital and liquidity rules • Role of ZLB 23