The Fed May Need to Head Off a Money-Market Mess
Comment of the Day

February 25 2021

Commentary by Eoin Treacy

The Fed May Need to Head Off a Money-Market Mess

This article by Bill Dudley may be of interest to subscribers. Here is a section:

What can the Fed do? For one, at their next policy-making meeting in mid-March, officials could slightly bump up the interest rates the central bank pays on bank reserves (currently 0.10%) and on its borrowings in the repo market (currently zero). A slightly higher floor on such rates might help prevent other short-term rates, such as yields on Treasury bills, from going negative. There’s precedent for such a move: The Fed has made technical adjustments to these rates before in order to ensure that the federal funds rate stays within the Fed’s target range.

Beyond that, the Fed should extend its temporary exemption of bank reserves and Treasury securities from leverage-ratio calculations (the initial exemption, granted last spring, is set to expire in March). I would even recommend going further and exempting bank reserves permanently. This would help solve a problem that arises when the Fed buys securities to stimulate the economy: Its purchases cause reserves to increase, bringing banks closer to the point where the leverage ratio requirement binds and forces them to curtail lending. When this happens, it undermines the Fed’s stimulus efforts. To ensure that the exemption wouldn’t reduce the amount of capital required to be held by banks, the leverage ratio and other capital requirements could be adjusted upwards.

Granted, the Fed might have a hard time selling such a move to other financial regulators, which don’t share its monetary policy mandate. But it would be the right thing to do, eliminating the inherent conflict between the Fed’s quantitative easing and bank leverage limits. Under the current regime, the Fed is adding accommodation with one hand, and taking it away with the other. That’s a strange way of doing business.

Eoin Treacy's view

The repo market is more than capable of sparking unwelcome volatility and the conditions for negative money market rates are growing. Some form of action will be required. Doing nothing will only exacerbate the problem. I suspect the Fed would much prefer removing inhibitions on bank liquidity than any form of interest rate hike regardless of how technical it would be.

This helps to highlight the Fed has challenges at both the long and short end of the curves. The yield curve spread continues to expand. The more sensitive 10-year - 3-month spread has jumped by almost 200 basis points in the last 18 months.

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