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The U.S. Fed’s new tools to control short-term rates

A Federal Reserve paper describes and evaluates monetary policy tools for managing short-term market rates in an environment of large-scale excess reserve money in the financial system. These tools are interest on excess reserves (IOER), reverse repurchase agreements (RRPs) with a wide range of market participants, and the term deposit facility (TDF).

“Federal Reserve Tools for Managing Rates and Reserves”
Federal Reserve Bank of New York, Staff Reports, September 2013, Number 64


The below are excerpts from the paper. Cursive text and emphasis have been added.

Pre-crisis short-term interest rate control

“Prior to the …financial crisis of 2007-2009, the Federal Reserve closely controlled the supply of reserves in the banking system through its open market operations (OMOs). In an OMO, the Federal Reserve buys or sells assets, either on a temporary basis (using repurchase agreements) or on a permanent basis (using outright transactions), to alter the amount of reserves held in the banking system. For example, purchasing Treasuries will increase the amount of reserves in the system.”

“By adjusting the supply of reserves in the system, the open market trading desk (the Desk) at the Federal Reserve Bank of New York could influence the level of the federal funds rate, the rate at which depository institutions lend reserves to each other. Depository institutions in the US are required to maintain a certain level of reserves, proportional to specified deposit holdings, which, in addition to precautionary demand for reserve balances, creates a demand curve for reserves. The interest rate at which the demand and the supply curves intersect increases when the Desk reduces the supply of reserves, for example. Through arbitrage, the level of the federal funds rate influences other short-term money markets rates.”

Large-scale liquidity supply and need for new instruments

“In response to the 2007-09 financial crisis and subsequent economic conditions, the Federal Reserve engaged in large-scale lending to financial institutions to provide liquidity and large-scale asset purchases to stimulate the economy by lowering interest rates. As a result of these policies, the amount of reserves in the banking system increased dramatically to over $2 trillion as of September 2013.”

“In light of the large-scale asset purchases and the large expansion of the balance sheet, the Federal Reserve has been preparing a variety of tools to ensure that short-term rates can be raised when needed. IOER has been used as one of these tools since October 2008; however two of these tools, RRPs with an extended range of counterparties, and the TDF, have not been implemented in large-value facilities as of yet.”

Interest on excess reserves

In October 2008, the Federal Reserve began paying interest on excess reserves IOER to depository institutions.. IOER differs from interest on reserves in that IOER is paid to reserve holdings in excess of the reserve requirement…IOER is offered to banks. It influences deposit rates as it represents the riskless return on an invested deposit at the Federal Reserve. It also sets a short-term reservation rate in the interbank market at which banks should not lend below”.

Money market rates have consistently remained below the IOER rate [mainly because the latter is paid only on banks’ excess reserves]. In June of 2011, the Federal Open Market Committee (FOMC) announced a strategy for the possible use of new tools geared towards influencing short-term market interest rates and keeping them close to the IOER.”

Full-allotment reverse repurchase agreement

“An reverse repurchase agreement (RRP) is economically equivalent to a collateralized loan made to the Federal Reserve by a financial institution. RRPs have historically been used, though somewhat infrequently, by the Federal Reserve in the conduct of monetary policy, arranged with a set of counterparties called “primary dealers… Reverse repurchase agreements do not change the size of the Federal Reserve’s balance sheet, but modify the composition of its liabilities. Indeed, each dollar of RRPs held by counterparties reduces one-for-one reserves held by depository institutions.”

“Federal Reserve RRPs provide an additional investment source for an expanded set of intermediaries, such as such as money market funds, government sponsored enterprises, and dealers, increasing both the number and the type of Federal Reserve counterparties. RRPs can be used to raise rates by diverting deposits away from banks and into Federal Reserve RRP non-bank counterparties. This supports deposit rates by reducing banks’ balance sheet size.”

“We find that RRPs work mainly through the household investment side but also serve to reduce reserves. RRPs can raise deposit rates in two ways: Decreasing balance sheet costs through reallocating depositor funds into Money market funds holding government bonds, which are not subject to balance sheet costs and liquidity shocks, and setting a reservation rate for short-term deposits that occur as a result of liquidity shocks.”

“RRPs may be fixed-rate, full-allotment or fixed-quantity, and may be term or overnight. Because the overnight rate reflects daily liquidity shocks, the fixed-rate, full-allotment overnight RRP is the most effective facility for setting a fixed reservation rate for those intermediaries; term or fixed-quantity RRPs cannot achieve the same level and stability of interest rates.”

Term deposit facility

“The temp deposit facility (TDF )is another policy tool that can reduce reserves but it is available only to Depository institutions. The TDF was approved in April 2010…allowing Federal Reserve Banks to offer term deposits to institutions eligible to earn interest on reserves. Small value temporary operational exercises of term deposits have occurred since June 2010, and recent small value operational exercises have been held in March, May, and July, and September of 2013…In comparison to the RRP, the TDF absorbs liquid reserves without reducing the size of bank liabilities and increases bank asset returns more directly.”

TDFs, in contrast to RRPs, do not reduce balance sheet costs. Therefore, when the banking system is forced to trade on costly interbank markets, RRPs increase the size of this interbank market by less than the TDF. This motivates usage of the reverse repurchase agreement and the term deposit facility concurrently. Namely when real marginal balance sheet costs and interbank lending costs are very convex, policy makers with the intention of raising deposit rates to high levels may want to use both facilities together.”

“If RRPs and the TDF are used in sufficiently large size, they can re-establish the interbank market by reducing the size of liquid reserves used to ward off liquidity shocks and can raise equilibrium bank asset returns.”


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