Key Highlights

• Three Fedspeakers discussed monetary policy implementation, repo markets and the balance sheet, highlighting the nexus that the Fed occupies across these topics
• Logan favors changing the Fed’s operating target, Bowman wants the SRF used only in emergencies, and Remache argues that money market volatility is “normal”
• We think that all of these issues are interlinked, and that open discussion of them is timely and useful

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Logan on Changing the Fed’s Operating Target

EXHIBIT #1: FED FUNDS MARKET DWARFED BY REPO

_{Source: BNY Markets, Federal Reserve Bank of Dallas}

The last three business days featured three important speeches by various Federal Reserve System officials. Dallas Fed President Lorie Logan proposed that the Fed replace the effective federal funds rate as an operating target for monetary policy with the tri-party general collateral rate (TGCR). The next day, Vice Chair for Supervision Michelle Bowman said that Fed backstops and liquidity facilities “should be activated for only the most exceptionally stressed circumstances,” rather than permanent and institutionalized. Finally, on Monday this week, Julie Remache of the New York Fed’s Open Market Trading desk argued that money market volatility seen at present is “…within limits… normal and not concerning.”

President Logan’s argument (further fleshed out in a related paper that she co-authored) hinged on the fact that the federal funds market is highly concentrated, restricted to a small subset of financial market participants, and that “connections between the fed funds market and broader money markets have grown fragile.” She points to the fact that TGCR can move materially at times, even while the effective federal funds rate (EFFR) stays stable and usually unchanged day-to-day, regardless of conditions in the broader money markets. On the other hand, its concentrated usage – 11 Federal Home Loan Bank Boards (FHLBs) are the main lenders in the federal funds market and only “relatively few bank borrowers.”

So, while the EFFR has remained largely unchanged even during times of bigger movements in repo rates, it ironically could see significant disruption if the FHLBs were to pull back from lending to the fed funds market. She points out that repo volumes dwarf participation in the federal funds market, which has remained remarkably steady over the years. Exhibit #1, reproduced from data presented in her co-authored paper referenced above, shows the growth of tri-party repo versus fed funds. With around $4.5tn in daily transactions, the former is some 11 times the size of the latter, which currently has around $100bn in daily participation. More than once in her remarks, she describes the secured money markets at the “center of gravity” in the system.

While this proposal is the first of its kind that we have heard Fed officials discuss publicly, we see the logic of the argument. Targeting TGCR would – in an ample reserves regime – allow it to fluctuate more in line with the daily level of reserves in the system. Recent observations suggest that this is not the case with EFFR. We don’t expect this to be undertaken lightly or quickly, if at all, but Logan’s arguments are intriguing and to our mind sensible. We recommend readers peruse the speech and related essay linked above.

Bowman on the Standing Repo Facility

EXHIBIT #2: SRF USAGE DURING MARKET STRESSES

_{Source: BNY Markets, Federal Reserve Board of Governors}

Vice Chair Bowman’s remarks featured a broad range of subjects, but we’ll concentrate on her view that the standing repo facility (SRF), currently a permanent backstop, increases the Fed’s “footprint” in financial markets and could dissuade counterparties in the money market from transacting at market rates. Furthermore, when such a nonmarket facility is offered, it ought to charge rates in excess of the top of the fed funds target range, to discourage its usage except in the most extreme stress episodes. This echoes the famous dictum from 19th century English financial write Walter Bagehot that in times of crisis, monetary authorities should “lend freely, at a penalty rate, against good collateral.”

Vice Chair Bowman envisions a lender of last resort type facility that should not be – in her words – “institutionalized” or “permanent.” However, as we pointed out last week (see here), we think that the most recent periods of market stress in early and mid-September revealed the presence of the SRF and its intermittent usage to be a stabilizing force in money markets, obviating the need for ad-hoc intervention by the Fed. We think of it as insurance rather than activist liquidity policy from the central bank. As we approach quarter-end we expect more tightness in money markets, especially now that systemwide reserves have dipped below $3tn as of last week.

The Fed has gone to great efforts to destigmatize usage of the SRF, in short promoting its use as a legitimate funding source when markets become tight. This strikes us as moving in the other direction from Bowman’s vision. Again, as with Logan’s, this speech makes a strong argument, but we don’t think we’ll see much movement on this idea for the time being. Obviously the makeup of the Fed board will be changing in coming months, and her case could see new adherents. Nevertheless – and again as with Logan’s proposal – it highlights the Fed’s ongoing critical thinking about its role in market stability, monetary policy implementation and the nexus between the two.

Remache on Money Market Volatility

EXHIBIT #3: REPO VOLATILITY RISING

_{Source: BNY Markets, Bloomberg}

Finally, we turn to New York Fed official Julie Remache’s speech this Monday. One of her key points is that the SRF has helped to achieve effective rate control, both in the EFFR market as well as across the constellation of money market rates associated with it. Furthermore, she maintains that as the balance sheet continues to be reduced, the system is moving away from an abundant reserve regime (one where changes in the level of reserves don’t affect EFFR) to an ample one, defined as one where reserves and their daily fluctuations make a difference in the level of rates.

The role of the SRF in this case is crucial, and as we argued last week, seemed to prevent significant dislocations in repo markets as reserves declined (much as most observers expected would happen at this point) while the balance sheet was reduced. As she stated, “On those occasions it worked consistent with its design, providing funds into the market when market rates rose above the SRF minimum bid rate. By doing so, the SRF can stem incipient rate pressure that, if left unaddressed, could threaten rate control.”

The takeaway from these three important speeches is that the Fed is being thoughtful and open in its consideration of operating instruments and their design and is open to questioning their effectiveness and suggesting changes. As the money markets transition from abundant to merely ample reserves, these debates highlight the nexus of both monetary policy and financial stability. These are conversations that will evolve and become more frequent, we suspect, and should not be overlooked. The thing that strikes us is that although they deal with nominally different concepts, the interrelations between the Fed’s monetary policy implementation and money markets rates with the balance sheet and the liquidity facilities is part of the same whole.

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