Money Markets and Monetary Policy

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Edwin Short
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1 Money Markets and Monetary Policy Financial Market Adaptation to Regulation and Monetary policy Stanford University March 20, 2015 James McAndrews Federal Reserve Bank of New York The views expressed in these slides are mine and do not necessarily reflect the views of the Federal Reserve Bank of New York or of the Federal Reserve System.

2 Evolution of the Federal Reserve s Balance Sheet 2

3 Monetary policy with large reserves Current policy concern: Interest on excess reserves (IOER) has not formed a floor for the fed funds rate Questions: Why are money market rates below IOER? Do we have the tools to raise market rates? If so, what is the most effective way to use our tools? Longer-term question: How should we implement monetary policy? 3

4 Monetary policy with large reserves Will present some facts and models from: Overnight RRP Operations as a Monetary Policy Tool: Some Design Considerations Josh Frost, Lorie Logan, Antoine Martin, Patrick McCabe, Fabio Natalucci, and Julie Remache, FRB Discussion Paper series Federal Reserve Tools for Managing Rates and Reserves, Antoine Martin, James McAndrews, Ali Palida, David Skeie, November 2014, mimeo, Federal Reserve Bank of New York Segregated Balance Accounts, Rodney Garratt, Antoine Martin, James McAndrews, Ed Nosal, forthcoming, Federal Reserve Bank of New York 4

5 Selected money market rates Interest on excess reserves (IOER) has not formed a floor for the fed funds rate (and other market rates) 5

6 Frictions limiting pass through of IOER Balance Sheet Costs Imperfect Competition FDIC assessment fee Limited # of counterparties Tier 1 leverage ratio Concentration limits 6

7 Federal Reserve Tools for Managing Rates and Reserves, We build a model with households, firms, banks, and nonbanks Banks face two main frictions: balance sheet costs (motivated by a leverage ratio requirement) interbank monitoring costs (crucial when reserves are scarce) Nonbanks do not face balance sheet costs In our model: Households use the financial system to save for consumption at a later date Firms produce consumption goods Banks lend to firms, offer deposits, and have access to IOER Nonbanks hold government debt on behalf of households and cannot earn IOER 7

8 When the supply of reserves is small Interbank market is active Interbank market frictions are high Balance sheet costs are low When the supply of reserves is high Interbank market is inactive Summary of results Interbank market frictions are low Balance sheet costs are high How can the central bank raise rates when the supply of reserves is very high? 8

9 New Federal Reserve Tools We study two tools (tested recently) Term Deposit Facility (TDF) Banks can deposit reserves with the Fed for a term maturity Reverse Repurchase agreements (RRPs) Banks and non-banks, such as MMFs, can lend to the Fed (against collateral) Of particular interest are fixed-rate overnight RRPs 9

10 How do the tools work? The tools work by affecting the two frictions that determine interest rates: Balance sheet costs: Reducing balance sheet size raises market rates by decreasing the spread to IOER Interbank market frictions: Increasing the interbank market activity raises interbank market rates Assessment: TDF: Creates reserve scarcity but does not affect balance sheet size RRPs: Creates reserve scarcity and reduce balance sheet size 10

11 Do we have the tools to raise rates? Yes, TDF and RRPs will help raise rates With large reserves, RRPs are more effective RRPs reduce balance sheet size Creating scarcity through TDF only would require massive drain of reserves 11

12 Selected money market rates, including the ON RRP offering rate Consistent with model, ON RRP strengthens floor on rates 12

13 ON RRP take-up versus spread to Treasury GCF rate Higher take-up of ON RRP when its rates exceed bill rates 13

14 Money market fund holdings of repo collateralized 14

15 ON RRP demand and rates with an aggregate cap 15

16 Another possible tool: SBAs SBAs are a proposed policy tool that directly attacks another possible friction in the market: imperfect competition for federal funds The manager also provided an update on staff work related to potential arrangements that would allow depository institutions to pledge funds held in a segregated account at the Federal Reserve as collateral in borrowing transactions with private creditors and which could potentially provide an additional supplementary tool during policy normalization. After further review, staff analysis suggested that such accounts involved a number of operational, regulatory, and policy issues. These issues raised questions about these accounts possible effectiveness that would be difficult to resolve in a timely fashion. It was therefore decided that further work to implement such accounts would be shelved for now. FOMC Minutes, December

17 What are SBAs? They are narrow bank accounts. SBAs are accounts that would be set up by a lender and any of the over 6,000 DIs (borrowers) that maintain accounts at a Federal Reserve Bank The account would be segregated from the DIs master account Loans made using SBAs are collateralized by the funds deposited in the SBA The DI earns IOER rate and the lender earns a negotiated rate Borrower cannot draw on the funds Facilitate credit-risk free lending (narrow accounts) 17

18 SBAs: Narrow bank accounts. 18

19 SBAs level the playing field regarding credit quality. Increase competition in money markets Improve the distribution of reserves and lower balance sheet costs 19

20 Two wedges: balance sheet costs and competitive frictions 20

21 Evidence suggests that fed funds rate is set at mark-up to ON RRP rate 21

22 Impact of SBAs Redistribution of reserves from high-cost to low-cost banks Equalization of marginal balance sheet costs Reduce imperfect competition friction Emphasis on price competition No need for concentration limits 22

23 Impact of SBAs 23

24 Natural Limit of Take-up 24

25 ON RRPs and SBAs ON RRPs are a direct investment at the Fed for certain counterparties, SBAs would be a market-intermediated investment, with reserves available as collateral to bolster the credit-quality of the borrower. ON RRP rate set by FOMC, SBA rate set in market by bank and counterparty. Some operational differences (time of day, closest substitute, ) Both have to address issue of potential for large flight to quality inflows in a crisis: should those be accommodated or not? 25

26 Concluding Thoughts Policy Normalization Principles and Plans, September 17, 2014: During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances. During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. The Committee will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate. Normalization will begin a new phase in the use of unconventional monetary tools to control interest rates. Further monitoring, model development, and empirical work will be important to interpret experience and to fine tune the use of these tools. 26

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Overnight RRP Operations as a Monetary Policy Tool: Some Design Considerations