The Federal Open Markets Committee is about to embark on the final leg of its unconventional monetary policy journey: raising rates and reducing its large balance sheet. The first step will be to move interest rates off zero. But to raise its rates with a large balance sheet new tools are required.
Implementing reverse repo, influencing yields
In the past, the Fed used a single fed funds rate to conduct policy. Going forward, the Fed will need to use a corridor approach to influence yields. The corridor’s ceiling will be a measure called Interest on Excess Reserves (IOER), the interest the Fed pays to banks on reserves the banks deposit at the Fed in excess of the required minimum. The Reverse Repo facility (RRP) will constitute the floor. (In this reverse repo facility, the Fed sells Treasury securities on the open market with an agreement to buy them back from its counterparty at a specified time in the future for a specified price. The difference between the sale price and the purchase price reflects the interest paid by the Federal Reserve for the cash provided by the counterparty). Although the Fed can enter into reverse repo agreements with banks, the RRP will target primarily money market funds. The traditional fed funds rate is then expected to float within this new corridor. While IOER has been successfully implemented over the past five years, there is a great deal of uncertainty over whether the RRP will provide a solid floor. Our analysis suggests the RRP will need to be upwards of $1 trillion.