and Dudley

Pres and CEO NY Federal Reserve Bank:

Two issues with the overnight reverse repo rate warrant careful consideration.  The first is how big a footprint the facility should have in terms of volume.  To the extent that the overnight RRP rate were set very close or equal to the interest rate on excess reserves (IOER) without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility.  This could encourage further development of the shadow banking system.  If this were deemed undesirable, this would argue for a wider spread between the overnight RRP and the IOER in order to reduce the volume of flows into the facility. 

However, if a financial crisis were to occur, the existence of a full allotment, overnight, RRP facility might exacerbate instability by encouraging runs out of more risky assets into the facility.  That is because the supply of a full allotment facility would be completely elastic at the given fixed rate.  Money market mutual funds and other providers of short-term financing could rapidly shift funds into the facility away from assets such as commercial paper that support the private sector.  In contrast, in the current regime, when financial crises lead to flows into less risky assets, their interest rates fall, limiting the appetite for these less risky assets.  Consequently, under a full allotment setup, runs could be larger and these runs could exacerbate the fall in the prices of riskier assets.  Note that the risk here is how quickly financial flows could reverse from one day to the next, not the average level of take-up of the facility over time

A second option to improve the Fed’s control over short-term rates is to drain reserves by offering banks term deposit accounts in which to invest funds for longer terms than overnight.  There are two issues that might make this option somewhat less attractive.  First, to strengthen monetary policy control significantly through this course, it might be necessary to drain most of the $3 trillion of reserves.  This could be done of course with effort, but is the effort worth it? 

Second, the Fed would undoubtedly have to “pay up” to induce banks to hold term deposit accounts relative to keeping their monies in reserves at the excess reserves interest rate.  This would likely result in higher Fed interest expenses relative to relying on an overnight RRP facility to set a floor on money market rates. 

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