Unfortunately, the Fed made a critical design error in its daily interventions. They are offering to supply repo to the dealers at prevailing market rates. In other words, they are giving the dealers every incentive to take repo from the Fed as opposed to the market. In essence, the Fed has become the lender of first resort when it should be the lender of last resort and offer repo at a penalty rate. The Fed should be willing to help a dealer in need, but it should come at a price.
So, after four months of these Fed repo operations, new problems are emerging. More specifically, the Fed might be going too far and oversupplying this market. The effective federal funds rate is signaling there are enough reserves in the banking system. This month it traded at 1.54%, breaking below the interest on excess reserves (IOER) floor of 1.55% for the first time in 14 months. This is happening as the Fed announces it will continue to plow ahead with Treasury bill purchases and supplying hundreds of billions of dollars of repo supply until April, if not later.
What should the Fed do? It has already telegraphed it will raise the IOER rate by five basis points to 1.60% at the Federal Open Market Committee meeting next week. Presumably, it will also raise the repo offered rate by five basis points to 1.60%. Policy makers should raise the repo rate even higher. Stand ready to offer liquidity, but at a penalty rate.
This won’t fix the problems in the repo market; only rule changes can do that. But at least this will allow the Fed to identify how much supply is needed to get the market back in balance rather than risking a loss of control of the federal funds rate altogether.
The Fed should not be looking to permanently insert itself into the repo market via a standing repo facility. Repo is still a credit market, and, in times of stress, it requires a credit decision when deciding who gets a collateralized loan and at what terms. Central banks are not equipped to make these decisions, and their involvement could create a moral hazard, making things worse.
The Fed panicked with their response to the repo market freeze in September. The “short-term” fix introduced had the desired effect and the monetary markets are once again flowing freely. However, the cost has been prohibitive and the big question today is whether this action is an example of what we can expect from the future or is it a once-off deal.
The speed and persistence of the uptrend since October reflects the broad conclusion that this is at least similar to additional quantitative easing. The primary difference after all is the Fed is buying short-dated in steady of long-dated paper. The clearer conclusion is it is a live example of modern monetary theory because the Fed is essentially funding the Federal deficit by buying its paper.
The challenge the Fed faces right now is they have no control over the political football of banking regulation. If they do in fact offer repo funds at a premium to the market that will only serve to raise the price of capital and is tantamount to an interest rate hike.
The repo action had had the effect of depressing short-term yields with the result the 3-month is only 5 basis points above the Fed’s lower bound for short-term rates. It gives the impression that the Fed is about to cut rates. Quite how they can tighten any form assistance right now is very questionable and that is what the continued rise in the stock is predicated on.
The Fed’s balance sheet remains in an uptrend and that represents about half the total central bank stimulus added to the global economy since October. As long as that trend is going up it remains a tailwind for the markets.Back to top