Simon Potter, executive vice president of the Federal Reserve Bank of New York, delivered a speech in Tokyo last week on "Implementation of Open Market Operations in a Time of Transition" in which he shared insights about the ON reverse repo facility, the Fed funds rate, and monetary policy normalization. He says, "At last week's meeting, the FOMC also reaffirmed its view that it likely will be appropriate to maintain the current zero to 1/4 percent target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. Meanwhile, as a matter of prudent planning, the Committee has been deliberating how it should proceed to remove policy accommodation (often called "normalization"), when it believes the appropriate time to do so comes.... In itself, an elevated level of reserve balances need not impede the FOMC's ability to effectively raise the level of short-term interest rates because of the ability to pay interest on excess reserves."
He continues, "Following last week's FOMC meeting, the Committee released a revised set of normalization principles and plans (taking into account changes in the SOMA portfolio and enhancements in available tools since it originally issued such principles in June 2011) that it intends to implement when it becomes appropriate to begin normalizing the stance of monetary policy. According to the principles, the Committee will adjust the level of monetary accommodation primarily by utilizing policy tools to influence the level of short-term interest rates -- in the first instance, using tools with rates directly administered by the Fed. Tools that can immobilize or drain large levels of reserves to tighten control over the federal funds rate also remain available."
Potter says, "Specifically, the FOMC indicated that the federal funds rate will continue to play a central role in the Fed's operating framework and communications during normalization, and that it will raise the target range for the federal funds rate when economic conditions warrant a less accommodative monetary policy stance. Adjustments in the interest rate that the Fed pays to depository institutions on excess reserve balances -- that is, the IOER rate -- will be the primary tool to move the federal funds rate into the target range. Raising the IOER rate should put upward pressure on a range of market interest rates and influence overall financial conditions in a way that fosters the Federal Reserve's macroeconomic objectives."
On RRP, he explained, "The Committee also indicated that an overnight reverse repurchase agreement (ON RRP) facility and other supplementary tools will be used, as needed, to help control the level of the federal funds rate. An ON RRP facility will supplement the primary role of IOER in controlling the federal funds rate by providing an alternative safe, overnight asset for money market investors.... The Federal Reserve will continue to test some of these tools to gather additional information about their efficacy and to enhance their operational readiness prior to liftoff. For the past year, the Desk has been conducting an exercise of ON RRP operations."
He tells us, "Conducting ON RRPs for same-day settlement with a broad range of counterparties -- including primary dealers, money funds, government-sponsored enterprises, and banks -- allows the Federal Reserve to provide a safe, liquid investment to a wider range of money market participants than those able to earn IOER, and thus expands the universe of counterparties that should generally be unwilling to lend at rates below those available through the Federal Reserve. The increased competition that the availability of this instrument provides should help to firm the floor on the level of short-term interest rates -- that is, the rate beneath which market participants should theoretically be unwilling to lend funds. All of the Desk's eligible counterparty types participate in the ON RRPs, with money funds accounting for the largest share of take-up. Take-up at the operations generally increases when the spread between market rates and the ON RRP offered rate narrows. Take-up also rises substantially around quarter- and year-end financial reporting dates, when some money market participants' access to other overnight secured investments is more limited. The increase in take-up on these dates is especially large for prime money market funds."
He went on, "As of Monday, the per-counterparty maximum bid limit was raised from $10 billion to $30 billion, and an overall size limit of $300 billion was imposed for each operation. If the total amount of bids received in an operation is less than or equal to the $300 billion size limit, awards will be made at a fixed offering rate. However, if the total amount of bids received exceeds the overall operation size limit, the $300 billion in ON RRPs will be allocated through a single-price auction using interest rates that counterparties now include with their bids. Awards are made at a "stopout rate" -- the rate at which the overall size limit is achieved -- with all bids below this rate awarded in full and all bids at this rate awarded on a pro rata basis. The stopout rate is determined by evaluating all bids in ascending order by submitted rate up to the point at which the total quantity of offers equals the overall size limit. The Federal Reserve will be closely analyzing the results of the ON RRP exercise conducted under these new testing parameters in order to further its understanding of how an ON RRP facility might best be structured during the initial stages of the normalization process."
He says, "Finally, I should note that central banks -- like other financial market participants -- need to remain aware of changes in the financial market landscapes in which they operate. They may need to adapt their operations accordingly as they move away from asset purchases and back to money market instruments to implement monetary policy. For example, in addition to reflecting developments in its balance sheet since the financial crisis, the FOMC's approach to normalizing policy also reflects changes in U.S. money market dynamics that have been influenced by various factors. These factors include the extraordinary level of liquidity that's been provided, access to IOER that is limited to depository institutions, and a number of international and domestic regulatory reforms. International regulatory reforms include the liquidity coverage ratio, leverage ratio, and net stable funding ratio. In the U.S., changes in deposit insurance premium calculations, rules governing money market mutual funds, and the potential for a capital surcharge based in part on short-term wholesale funding may also affect certain market participants."
Potter concludes, "Many of the changes in regulation -- along with changes in market structure, technology, and other factors -- may affect market participants' activity and relationships in money markets. On net, their balance sheet costs may be higher, which may prompt money market participants to require higher returns to engage in competition to arbitrage wedges in money market rates and to alter their participation in central bank operations and facilities. This outcome may affect the transmission of monetary policy or require central banks to adapt their operations to accommodate these realities."
