For lovers of the minutiae of monetary-policy plumbing, this week’s snafu in the money market is fascinating. For everyone else, it probably doesn’t matter. This week, the Federal Reserve was caught off guard by an unexpected spike in banks’ short-term funding costs, and acted quickly. It offered U.S. lenders three rounds of liquidity and lowered the returns given to them on several of its facilities. The rates on overnight repurchase agreements, or repos—a common way of borrowing funds that involves pledging assets as collateral—have now sunk to 1.75%, after closing at 7% Tuesday.
Repo trouble has set alarm bells ringing in the investment community, because this obscure corner of the market also seized up during the financial crisis. Closer examination, however, reveals a different picture from 2008: Banks don’t seem stressed for funding, nor are suspect mortgage-backed securities at the center of the chaos. Rather, it has been driven by a surge in the repo rate on Treasurys—extra-safe paper that remains in high demand. This time, the repercussions may be contained to the reassuringly mundane world of monetary technicalities.
Say that a government agency with the ability to produce apples at no cost had a target to fix the market price of apples at $1. It could make sure that apples are structurally scarce, and then sell enough of them every day to push the price down to $1. Alternatively, it could flood the market with more apples than anybody wants so they are practically worthless, and then offer to buy the surplus for $1. Consumers wouldn’t care about which of the two is going on, because both would achieve the same result: apples would cost $1. The same is true for central banks and the “reserves” that they print, which are needed by commercial banks to settle debts. The Fed’s recent moves are just tweaks to the instruments used to fix the market price of reserves. They don’t affect what that price target actually is. Before 2008, the Fed used the scarcity technique to make sure the market was always short of reserves. Then officials decided to buy a lot of bonds to help the economy. This required printing a lot of money, or quantitative easing, forcing the Fed to switch to the overabundance approach: It fixed rates by offering a certain return on all those excess reserves. Now that policy is being reversed, and the old way of doing things—bouts of scarcity followed by the Fed injecting money—is back.
The Fed this week acted quickly to respond to an unexpected spike in banks’ short-term funding costs.
Andrew Harrer/Bloomberg News
Admittedly, the repo-rate jump is surprising given that there are still $2.4 trillion more reserves now than in 2008. But there are simple explanations for why more reserves are now needed to achieve the same result: Regulators now force banks to hold more liquid assets, and have clamped down on the dangerous intraday credit facilities that repo borrowers used to resort to. Also, cash was in high demand this week because companies paid their corporate taxes. To be sure, the full effects of new regulations are still unknown and may need addressing. High-quality assets have sometimes become scarce, and overseas borrowers without access to the Fed often struggle to source enough U.S. dollars. But in this case, the problem was caused by domestic banks not having enough of what the Fed has infinite ability to create: reserves. The solution has proven correspondingly simple: giving them more reserves. The Fed has announced that rates will be between 1.75% and 2%. Investors don’t need to read the technical manual to know this is where they will end up. Write to Jon Sindreu at firstname.lastname@example.org
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