The new reverse repo program was originally intended to help officials tighten policy by improving their control over short-term borrowing costs. Fed staff members gave a presentation on the possibility of the tool at the FOMC’s meeting in July, and the Federal Reserve Bank of New York began testing the operation in September.
The Fed in 2008 gained the authority to pay interest on banks’ excess reserves as a way to regulate the supply of credit to the economy. By raising the rate, the Fed could encourage banks to keep excess funds parked at the central bank. Lowering it would urge them to lend to customers.
Excess reserves have mushroomed as the Fed purchased securities from banks in its bid to spur growth by lowering long-term interest rates. Banks had about $2.4 trillion in extra cash at the Fed as of Nov. 27, according to data from the central bank.
Yet IOER has limited effectiveness in precisely controlling short-term rates because only banks are allowed to keep money on deposit at the central bank. Other financial firms that borrow and lend in the interbank money markets, such as mortgage- finance companies Fannie Mae and Freddie Mac, aren’t eligible.
The federal funds effective rate was 0.09% yesterday and has traded below IOER for four years. The rate, the average for overnight loans among banks, is the Fed’s benchmark.
The new tool, called the fixed-rate, full-allotment overnight reverse repurchase facility, is intended to put a floor under short-term money-market rates, which could prevent them from falling below zero if the Fed were to cut IOER. It allows banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed unlimited amounts of cash overnight at a fixed rate, currently 0.05%, in exchange for borrowing Treasuries in reverse repo transactions.
In a reverse repo, the Fed lends securities for a set period, temporarily draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to its counterparties.
The Fed’s tests since September have been going well, according to Simon Potter, head of the New York Fed’s markets group, which implements the central bank’s monetary policy.
“Market participants generally characterize the exercise as smooth, with minimal disruptions,” Potter said in a Dec. 2 speech. “Money-market experts have noted the exercise’s importance in the current environment of promoting market functioning; for example, it reduces the likelihood of pervasive, negative short-term rates trading.”
An average of $6.6 billion a day has been used under the program since Sept. 23. The repo tool has helped lift the rate for borrowing and lending Treasuries for one day to an average of 0.066% as of Dec. 10, from 0.051% the day the program was announced Sept. 20, according to a Deposit Trust & Clearing Corp. General Collateral Finance Treasury Repo Index.
Copyright 2014 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.