Money Markets and Monetary Policy
Financial Market Adaptation to Regulation and Monetary policy
Stanford University
March 20, 2015
James McAndrews
Federal Reserve Bank of New York
The views expressed in these slides are mine and do not necessarily reflect the views of the Federal
Reserve Bank of New York or of the Federal Reserve System.
Evolution of the Federal Reserve’s Balance Sheet
2
Monetary policy with large reserves
 Current policy concern:
 Interest on excess reserves (IOER) has not formed a floor for the
fed funds rate
 Questions:
 Why are money market rates below IOER?
 Do we have the tools to raise market rates?
 If so, what is the most effective way to use our tools?
 Longer-term question:
 How should we implement monetary policy?
3
Monetary policy with large reserves
Will present some facts and models from:
“Overnight RRP Operations as a Monetary Policy Tool: Some
Design Considerations”
http://www.federalreserve.gov/econresdata/feds/2015/files/2015010pap.pdf
Josh Frost, Lorie Logan, Antoine Martin, Patrick McCabe, Fabio
Natalucci, and Julie Remache, 2015-10 FRB Discussion Paper series
“Federal Reserve Tools for Managing Rates and Reserves,”
Antoine Martin, James McAndrews, Ali Palida, David Skeie, November 2014, mimeo,
Federal Reserve Bank of New York
“Segregated Balance Accounts,” Rodney Garratt, Antoine Martin, James
McAndrews, Ed Nosal, forthcoming, Federal Reserve Bank of New York
4
Selected money market rates
Interest on excess reserves (IOER) has not formed a floor for the fed funds rate
(and other market rates)
5
Frictions limiting pass through of IOER
Balance Sheet Costs
Imperfect Competition
FDIC assessment fee
Limited # of counterparties
Tier 1 leverage ratio
Concentration limits
6
“Federal Reserve Tools for Managing Rates and Reserves,”
 We build a model with households, firms, banks, and nonbanks
 Banks face two main frictions:
 “balance sheet” costs (motivated by a leverage ratio requirement)
 interbank monitoring costs (crucial when reserves are scarce)
 Nonbanks do not face balance sheet costs
 In our model:
 Households use the financial system to save for consumption at a
later date
 Firms produce consumption goods
 Banks lend to firms, offer deposits, and have access to IOER
 Nonbanks hold government debt on behalf of households and cannot
earn IOER
7
Summary of results
 When the supply of reserves is small
 Interbank market is active
 Interbank market frictions are high
 Balance sheet costs are low
 When the supply of reserves is high
 Interbank market is inactive
 Interbank market frictions are low
 Balance sheet costs are high
 How can the central bank raise rates when
the supply of reserves is very high?
8
New Federal Reserve Tools
 We study two tools (tested recently)
 Term Deposit Facility (TDF)
 Banks can deposit reserves with the Fed for a term maturity
 Reverse Repurchase agreements (RRPs)
 Banks and non-banks, such as MMFs, can lend to the Fed (against
collateral)
 Of particular interest are fixed-rate overnight RRPs
9
How do the tools work?
 The tools work by affecting the two frictions that
determine interest rates:
 Balance sheet costs: Reducing balance sheet size raises market
rates by decreasing the spread to IOER
 Interbank market frictions: Increasing the interbank market activity
raises interbank market rates
 Assessment:
 TDF: Creates reserve scarcity but does not affect balance sheet
size
 RRPs: Creates reserve scarcity and reduce balance sheet size
10
Do we have the tools to raise rates?
 Yes, TDF and RRPs will help raise rates
 With large reserves, RRPs are more effective
 RRPs reduce balance sheet size
 Creating scarcity through TDF only would require massive
drain of reserves
11
Selected money market rates, including the ON RRP offering rate
Consistent with model, ON RRP strengthens floor on rates
12
ON RRP take-up versus spread to Treasury GCF rate
Higher take-up of ON RRP when its rates exceed bill rates
13
Money market fund holdings of repo collateralized
14
ON RRP demand and rates with an aggregate cap
15
Another possible tool: SBAs
 SBAs are a proposed policy tool that directly attacks another
possible friction in the market: imperfect competition for federal
funds
“The manager also provided an update on staff work related to potential arrangements that
would allow depository institutions to pledge funds held in a segregated account at the
Federal Reserve as collateral in borrowing transactions with private creditors and which
could potentially provide an additional supplementary tool during policy normalization. After
further review, staff analysis suggested that such accounts involved a number of
operational, regulatory, and policy issues. These issues raised questions about these
accounts’ possible effectiveness that would be difficult to resolve in a timely fashion. It was
therefore decided that further work to implement such accounts would be shelved for now.”
FOMC Minutes, December 2014
16
What are SBAs? They are “narrow bank” accounts.
 SBAs are accounts that would be set up by a lender and any of
the over 6,000 DIs (borrowers) that maintain accounts at a
Federal Reserve Bank
 The account would be segregated from the DIs’ master account
 Loans made using SBAs are collateralized by the funds
deposited in the SBA
 The DI earns IOER rate and the lender earns a negotiated rate
 Borrower cannot draw on the funds
 Facilitate credit-risk free lending (narrow accounts)
17
SBAs: Narrow bank accounts.
18
SBAs level the playing field regarding credit quality.
 Increase competition in money markets
 Improve the distribution of reserves and lower balance sheet
costs
19
Two wedges: balance sheet costs and competitive frictions
20
Evidence suggests that fed funds rate is set at mark-up to ON RRP rate
21
Impact of SBAs
 Redistribution of reserves from high-cost to low-cost banks
 Equalization of marginal balance sheet costs
 Reduce imperfect competition friction
 Emphasis on price competition
 No need for concentration limits
22
Impact of SBAs
23
Natural Limit of Take-up
24
ON RRPs and SBAs
ON RRPs are a direct investment at the Fed for certain
counterparties, SBAs would be a market-intermediated
investment, with reserves available as collateral to bolster the
credit-quality of the borrower.
ON RRP rate set by FOMC, SBA rate set in market by bank and
counterparty.
Some operational differences (time of day, closest substitute,…)
Both have to address issue of potential for large flight to quality
inflows in a crisis: should those be accommodated or not?
25
Concluding Thoughts
Policy Normalization Principles and Plans, September 17, 2014: “During normalization,
the Federal Reserve intends to move the federal funds rate into the target range set by the
FOMC primarily by adjusting the interest rate it pays on excess reserve balances. During
normalization, the Federal Reserve intends to use an overnight reverse repurchase
agreement facility and other supplementary tools as needed to help control the federal
funds rate. The Committee will use an overnight reverse repurchase agreement facility only
to the extent necessary and will phase it out when it is no longer needed to help control the
federal funds rate.”
http://www.federalreserve.gov/newsevents/press/monetary/20140917c.htm
Normalization will begin a new phase in the use of unconventional
monetary tools to control interest rates.
Further monitoring, model development, and empirical work will be
important to interpret experience and to fine tune the use of these tools.
26