Potter Says New Repo Tool Should Increase Fed’s Control of Rates

Potter Says New Repo Tool Should Increase Fed’s Control of Rates

Simon Potter, the Federal Reserve Bank of New York’s markets group chief, said the Fed’s reverse repurchase agreement program now being tested will probably play a central role in the eventual removal of record stimulus. Market “participants have indicated that they expect that a facility, if executed in full scale in the future, should be an effective tool for increasing the Federal Reserve’s control of short-term money market rates,” Potter said today in the text of speech in New York. He is in charge of the System Open Market Account used in implementing monetary policy.Fed officials have been testing the new tool — known as a fixed-rate, full allotment overnight reverse repo facility — aimed at improving their control of near-term borrowing costs when they tighten policy by siphoning off excess cash in the banking system.

“Operationally, market participants generally characterize the exercise as smooth, with minimal disruptions,” Potter said.

The program would allow 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 percent, in exchange for borrowing Treasuries in so-called 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.

Excess Reserves

Used along with the Fed’s ability to pay interest on excess reserves, the repo facility “may strengthen the floor for short-term interest rates and, with it, the Federal Reserve’s control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank’s payment of interest to a wider universe of relevant counterparties,” Potter said.

The Fed has been extracting cash from the money markets with the tool since September, which is starting to create a floor for short-term rates.

The operations have helped lift the rate for borrowing and lending Treasuries for one day to an average 0.11 percent as of Nov. 29. That’s up from 0.051 percent the day the program was announced Sept. 20, according to a Deposit Trust & Clearing Corp. General Collateral Finance Treasury Repo Index.

While the Fed gained the ability in 2008 to pay interest on cash it holds in the form of excess reserves, or IOER, that tool has had limited effectiveness in anchoring borrowing costs because only banks are able to earn such interest.

‘Strengthening’ Floor

“The facility is expected to complement IOER, strengthening the floor on the level of overnight rates and tightening the relationship among various money market rates,” Potter said.

“Improved control over the level of money-market rates and reduced volatility of short-term interest rates could enhance the flexibility of the desk’s operational tools, ultimately allowing for a more robust and effective implementation of the” Federal Open Market Committee’s (FDTR) “policy directives both during the rate normalization period and when there is a very large balance sheet,” Potter said.

The central bank in three rounds of asset purchases has expanded its balance sheet to a record of more than $3.9 trillion.

To contact the reporter on this story: Caroline Salas Gage in New York at csalas1@bloomberg.net