I wish I could have sat in that meeting, watching the bewildered faces of Fed officials as they got hourly updates on repo rates blowing out.
The FOMC meeting minutes released this afternoon – instead of being stuffed with mind-numbing language – were spiked with a practically riveting account of the repo fiasco as it was unfolding over September 17 and 18 while the FOMC was meeting.
The account lays out some reasons behind the repo fiasco, the Federal Reserve’s reaction to it, and the changes it implemented and is going to implement to prevent the repo fiasco from spiraling further out of control.
Deep trouble in the repo market that caused “volatility in unsecured rates” had already percolated into the minutes of the July 30-31 FOMC meeting. But apparently nothing had prepared Fed officials for what would happen in the repo market on September 16, the day before their meeting, and on September 17 and 18, as they were meeting: Repo rates blew out.
I wish I could have sat in that meeting, watching the bewildered faces of Fed officials, Fed staff, and other participants as they were getting hourly updates on where repo rates were at the moment.
Day 1 of the meeting: repo rates blew out, Fed responded with $75 billion repo. From the minutes:
“Money markets were stable over most of the period [since the last meeting], and the reduction in the interest on excess reserves (IOER) rate following the July FOMC meeting fully passed through to money market rates.
“However, money markets became highly volatile just before the September meeting, apparently spurred partly by large corporate tax payments and Treasury settlements, and remained so through the time of the meeting.
“In an environment of greater perceived uncertainty about potential outflows related to the corporate tax payment date, typical lenders in money markets were less willing to accommodate increased dealer demand for funding.
“Moreover, some banks maintained reserve levels significantly above those reported in the Senior Financial Officer Survey about their lowest comfortable level of reserves rather than lend in repo markets [and so they didn’t lend to the repo market].
“Money market mutual funds reportedly also held back some liquidity in order to cushion against potential outflows.
“Rates on overnight Treasury repurchase agreements rose to over 5 percent on September 16 and above 8 percent on September 17. Highly elevated repo rates passed through to rates in unsecured markets.”
“Federal Home Loan Banks reportedly scaled back their lending in the federal funds market in order to maintain some liquidity in anticipation of higher demand for advances from their members and to shift more of their overnight funding into repo.
“In this environment, the effective federal funds rate (EFFR) rose to the top of the target range on September 16.
“The following morning, in accordance with the FOMC’s directive to the Desk to foster conditions to maintain the EFFR in the target range, the Desk conducted overnight repurchase operations for up to $75 billion. After the operation, rates in secured and unsecured markets declined sharply. Rates in secured markets were trading around 2.5 percent after the operation.
“Market participants reportedly expected that additional temporary open market operations would be necessary both over subsequent days and around the end of the quarter. Many also reportedly expected another 5 basis point technical adjustment of the IOER rate.”
Day 2 of meeting: second repo, from later in the minutes:
“Open market operations conducted on the previous day had helped to ease strains in money markets, but the EFFR had nonetheless printed 5 basis points above the top of the target range. With significant pressures still evident in repo markets and the federal funds market, and in accordance with the FOMC’s directive to maintain the federal funds rate within the target range, the Desk conducted another repo operation on the morning of the second day of the meeting.
“The staff presented a proposal to lower the IOER rate and the overnight reverse repurchase agreement rate by 5 basis points, relative to the target range for the federal funds rate, in order to foster trading of federal funds within the target range.”
Repo-rate blowout threw Fed’s policy into turmoil.
With overnight rates and the EFFR blowing out and escaping the Fed’s control, something wasn’t working as planned, and a new policy with different elements is now on the front burner to deal with these issues, particularly:
To increase balances of excess reserves that banks keep at the Fed – the “ample reserves” – so that banks would be incentivized to provide liquidity to the repo market, which they failed to do during those tumultuous days.
This means the Fed starts buying Treasury securities again – and as it pointed out, only short-term Treasury bills. But this is not QE, the minutes say emphatically, and the idea that this is not QE needs to be communicated to the markets, the minutes also say emphatically.
To dust off its “standing repo facility,” which is what the Fed used to have before September 2008, when it abandoned it in favor of QE and zero-interest-rate policy.
From the minutes, underscore added:
“Participants agreed that developments in money markets over recent days implied that the Committee should soon discuss the appropriate level of reserve balances sufficient to support efficient and effective implementation of monetary policy in the context of the ample-reserves regime that the Committee had chosen.
“A few participants noted the possibility of resuming trend growth of the balance sheet ["trend growth” was about 4% per year before 2008] to help stabilize the level of reserves in the banking system.
“Participants agreed that any Committee decision regarding the trend pace of balance sheet expansion necessary to maintain a level of reserve balances appropriate to facilitate policy implementation should be clearly distinguished from past large-scale asset purchase programs that were aimed at altering the size and composition of the Federal Reserve’s asset holdings in order to provide monetary policy accommodation and ease overall financial conditions.”
“Several participants suggested that such a discussion could benefit from also considering the merits of introducing a standing repurchase agreement facility as part of the framework for implementing monetary policy.”
Fed Chair Jerome Powell supplied some additional tidbits.
Yesterday, Powell came out and explained how the Fed would undertake these asset purchases: The Fed would buy short-term Treasury bills only. Longer-term Treasury securities would not be purchased under this program. By buying only short-term Treasury bills, long-term rates should not be impacted, and therefore these purchases should not act as a stimulus, Powell’s logic went – though buying short-term Treasury bills is precisely what the Fed had done during the early phases of QE.
But what brought long-term rates down during QE was Operation Twist, under which the Fed shed its short-term securities and replaced them with long-term securities; and QE-3, which was entirely focused on longer-term Treasury securities and Mortgage Backed Securities. By the time QE ended, the entire Fed portfolio was composed of longer-term securities with the average maturity exceeding 8 years.
Under the new-new plan, the average maturity would decrease at a faster rate than under the old-new plan outlined earlier this year, which should eventually contribute to a steepening of the yield curve.
In an initial reaction, since Powell’s explanation yesterday, and supported by the minutes this afternoon, all Treasury yields of 2 years and longer rose, with the 10-year Treasury yield up 7 basis points to close today at 1.59%.
The hullabaloo in the repo market torpedoed the function of Interest on Excess Reserves and forced the Fed to go back to the future. Read... Fed Admits Failure of ‘Plan A’ to Control Money Market Rates, Shifts Back to Repos (which was ‘Plan A’ till 2008)