Simon M Potter: Money markets after liftoff - assessment to date and the
road ahead
Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the Federal
Reserve Bank of New York, at the 70th Anniversary Celebration of the School of International
and Public Affairs at Columbia University, New York City, 22 February 2016.
* * *
The footnotes can be found at the end of the document.
The charts can be found at the Federal Reserve Bank of New York's website:
Thank you. It's an honor to speak to you today as part of the 70th Anniversary Celebration of
the School of International and Public Affairs at Columbia University, and I would like to thank
my former colleague and longtime friend Trish Mosser for the invitation. The programs offered
by SIPA, which aim to train young leaders to address the world's most pressing public policy
problems, are especially relevant to the mission of the New York Fed, and many members of
the Bank's Markets Group are alumni.1
I'm here to offer a few thoughts on money markets and the implementation of monetary policy.
Because of the large size of the Federal Reserve's balance sheet, the staff at the Federal
Reserve spent the past several years developing a new and innovative framework to control
money market rates, and working to increase the amount of data we receive about trading in
those markets. In my remarks today, I will review the performance of this new framework and
discuss key insights from those new data collections.
Before 2008, bank reserves were scarce, and the Federal Reserve influenced overnight
interest rates by making small adjustments in the supply of reserves. The expansion in the
Federal Reserve's balance sheet during and after the financial crisis means that reserves are
now abundant, and small adjustments in the quantity of reserves will not have much influence
on overnight interest rates. Instead, the Federal Reserve's new framework is premised on the
payment of interest on reserves and on ensuring sufficient competition in money markets so
that the rate of interest paid on reserves is passed through to other money market rates and
thus to deposit rates offered to households and firms.2
Implementing policy in this new way has required a significant shift in the staff's analytical
focus, toward quantitative, data-driven analysis of money market structure. This work was
accomplished by a large roster of highly talented staff at the Board of Governors, the New York
Fed, and elsewhere in the Federal Reserve System. Of course, the development of this new
framework entailed frequent interaction with the Board of Governors and the Federal Open
Market Committee (FOMC), which are responsible for the tools used to implement monetary
policy.
I'll focus my remarks on a few key questions.
First, what is this new framework and why was it necessary? In this section, I will explain why
the Federal Reserve was able to lift rates off zero without requiring large-scale "reserve
draining."3
Next, what do the new data on money market trading say about how this new framework is
affecting market conditions? As part of this discussion, I'll walk through the enhanced data
that, starting in March, the New York Fed will use to calculate the effective federal funds rate.4
Finally, what questions remain, and what can be done to learn more about the issues they
raise? These include the level of capacity required in the Federal Reserve's reverse repo
operations and the consequences of changes in the regulatory rules for banks and money
funds.
As always, these views are mine alone and do not necessarily reflect those of the New York
Fed or the Federal Reserve System.
A new approach for policy implementation
Why are we following a new approach to implementing monetary policy?
Before the financial crisis, the Federal Reserve followed a well-worn playbook for monetary
policy implementation that was based on scarcity of reserves. Reserves left at the Federal
Reserve earned zero percent interest. As a result, to achieve the FOMC's desired level of the
federal funds rate, the Open Market Desk at the New York Fed (Desk) estimated the amount
of reserves to add or subtract that would intersect supply and demand at the target interest
rate directed by the FOMC.5 All else equal, if the Desk wanted interest rates to go up, it slightly
reduced the amount of reserves; if it wanted rates to go down, it slightly increased the amount.6
So long as the Desk was able to effectively forecast the appropriate amount of reserves to add
or subtract, temporary open market operations provided it with an efficient means to add or
subtract them, and therefore allowed for good control over the federal funds rate.7 These
operations were conducted as repos or reverse repos secured by Treasury securities or other
high-quality collateral.8
Back then, a typical day on the Desk focused on forecasting the demand for reserves created
by reserve requirements and other sources, and projecting autonomous factors affecting
10
reserves.9, With very small amounts of excess reserves in the system, there was a
straightforward relationship between rates in a range of money markets. Thus, the Desk was
able to target a rate in one part of the unsecured market by conducting small secured
operations as needed with primary dealers.
Since the financial crisis, the environment has changed in two important ways. First, by the
end of 2014, following the large-scale asset purchase programs, the Federal Reserve balance
sheet was funded by about $3.1 trillion in liabilities other than Federal Reserve notes, which
were mostly in the form of reserves in excess of the amount banks were required to hold; in
contrast, there were only $64 billion of non-Federal Reserve note liabilities in June 2007, of
which only about $2 billion were excess reserves. As a result, reserves are now anything but
scarce. Second, Congress granted the Federal Reserve an important new tool: the authority
to pay interest on reserve balances, or IOR.11
In many countries, and in theory, a standing facility that pays IOR provides a floor on interest
rates. The reason is simple: if a private counterparty can invest cash at the central bank, then
given the safety and convenience of this investment, it will dominate any other overnight
investment at that interest rate. Further, if banks can acquire funds in the wholesale market at
rates below IOR, then competition for these funds will bid up these rates close to that paid on
reserves.
The Federal Reserve instituted interest on reserves in late 2008, and the interest rate on
reserves turned out not to be a floor; market interest rates fell significantly below it. With the
large levels of excess reserves in the system, certain institutional aspects of money markets
in the United States - including bank-only access to IOR, credit limits imposed by lenders and
other impediments to market competition, and the costs of balance sheet expansion - appear
to create frictions that have made IOR act more like a magnet that pulls up short-term interest
rates than a firm floor beneath them. Thus, in considering how to implement policy
normalization, the Federal Reserve evaluated a variety of ways to increase competition for
funds among borrowers and thereby improve the control provided by IOR.12
The Federal Reserve initially considered an approach to policy normalization that was based
on a combination of term operations and asset sales or redemptions aimed at making reserves
sufficiently scarce so that, once the FOMC decided to tighten monetary policy, this tightening
could be implemented using IOR within a framework that was otherwise similar to that used
before the crisis.13 As part of this approach, the Federal Reserve acquired a new set of reverse
repo counterparties, including money market funds and government-sponsored enterprises, in
addition to the primary dealers with which it had traditionally transacted. These new
counterparties were major investors of cash in overnight markets and had capacity to facilitate
the "draining" of substantial reserve balances, if offered attractive term investments with the
Federal Reserve. In addition, the Federal Reserve developed a term deposit facility to drain
banks' reserve balances.14 This playbook of draining reserves back to reserve scarcity to
support the transmission of interest on reserves into market rates is standard among central
banks. If policymakers had chosen to do so, the Federal Reserve could have made such a
term reserve draining approach work to help control money market rates in the United States.15
So, why did the Federal Reserve not follow this approach of large-scale reserve draining? As
the balance sheet continued to grow as a result of asset purchase programs, it became
apparent that such reserve draining operations would have been very large in comparison to
the size of private money markets. As a result, they probably would have had lasting effects
on the structure of those markets - for example, by reshaping the structure of term money
market activity according to the structure of the Federal Reserve's operations. These lasting
effects could have been especially large if the balance sheet did not run off quickly.
For this reason, the Federal Reserve instead pursued offering an overnight investment
opportunity that could, with sufficient capacity, intensify competition in money markets and,
without necessarily draining reserves, enhance the transmission of IOR into other overnight
money market rates. This approach entailed a twist on a traditional Federal Reserve tool,
reverse repos: Instead of running quantity-based, term operations aimed at altering reserve
levels, the Desk would run interest-rate-based overnight operations aimed directly at
influencing market rates.
A number of operational features were required to implement such an overnight reverse repo,
or ON RRP, facility: It would need same-day settlement;16 the operation would need to be run
predictably, every day, and as late in the day as possible, to give lenders time to bargain with
other counterparties using the outside option of investing with the Federal Reserve;17 an
appropriate spread below IOR would be required to ensure that the facility neither induced
large changes in the structure of money markets nor lost the ability to support interest rate
control;18 and the operations would need enough unused capacity that lenders could credibly
propose to leave borrowers that did not offer an adequate interest rate.19
This approach works in theory, and, with the support of staff across the Federal Reserve
System, a theoretical framework was developed around money market rate control through
the use of this framework.20 The ON RRP facility was also tested for more than two years. This
theoretical and empirical examination gave the Federal Reserve confidence that it could
effectively raise rates when the time came while limiting undesirable effects on financial market
structure, and also ensured that additional term tool options were available if the combination
of the overnight tools - IOR and ON RRP - was not sufficient to provide interest rate control.21
At this point, you might have a question: from late 2008 to late 2015, the federal funds rate
traded well within the FOMC's target range of zero to 25 basis points.22 Shouldn't this have
been conclusive evidence as to the ability of the operational framework to provide sufficient
control of interest rates?
Unfortunately, the answer is no, because there are natural features of the financial system that
likely provide support to interest rates near the zero lower bound, or ZLB. These features
include the availability of physical cash and a behavioral aversion by some money market
investors to investing at negative rates, and also encompass certain unique features of money
markets in the United States, such as legal and regulatory incentives applicable to money
market mutual funds and the ability of the government-sponsored enterprises to leave
unremunerated deposits at the Federal Reserve.23
As a result, while the pre-liftoff testing suggested that the tools were likely to work well, it wasn't
possible to determine with complete certainty the extent to which market rates were driven by
the tools or by ZLB effects. So we couldn't completely rule out that the federal funds rate and
other money market rates might not go up one for one with rises in administered rates. One
might also worry that money market rates might not move together as rates rise, meaning that,
for example, a disconnect might emerge between secured and unsecured rates, or between
overnight and term instruments.24 Either situation could result in impaired transmission of
monetary policy into broad financial conditions.
Assessing the performance of the new framework
To summarize my conclusion about the performance of the operating framework to date: I am
extremely pleased with what we've seen so far.
In discussing why I view the framework as effective, it's helpful to start by explaining what it
means for the tools to work well. I think about this issue through three lenses: interest rate
control, avoiding unintended impact on the structure of the financial system, and avoiding
financial instability. I'll touch on what each of these mean, and then I'll review the quantitative
evidence since liftoff on how well things have gone.
Interest rate control
Clearly, interest rate control is the paramount objective. It is of great importance that the public
is confident that the federal funds rate will be, on average over time, within the target range
set forth by the FOMC, and that other money market rates will continue to move closely with
changes in the federal funds rate. This way, expectations for the FOMC's future policy stance
will be properly incorporated into the term structure of interest rates, and thereby appropriately
affect broad financial conditions and the broader economy.
It's not necessary that the effective rate stay within the target range each and every day. Before
the crisis, there was usually a bit of variability in the effective rate owing to limitations on the
Desk's ability to achieve completely precise daily forecasts for reserve demand. Now, as I said
earlier, the FOMC sets the target as a range, not as a point value. The federal funds rate can
vary within that range, and it could even move outside that range on occasion, without
materially affecting the economy.25
We have instituted a data-driven, cross-market framework for evaluating interest rate control.
In unsecured markets, we gather daily, transaction-level data through a new Federal Reserve
statistical collection called the FR 2420. These rich data give us much greater insight than we
had before the crisis about how these markets are structured, which is important to developing
and maintaining an operating regime based on improving competition among borrowers in
money markets, in the context of a large amount of reserves and substantial ongoing regulatory
and business model changes.
Monetary control does not stop at the effective federal funds rate: The Federal Reserve also
wants to ensure that the stance of monetary policy is passed through into other money market
rates. For example, we evaluate such transmission in the Treasury tri-party repo market, the
market in which ON RRP is conducted, by collecting similar trade-by-trade data from clearing
banks. In addition to these overnight markets, we pay close attention to the Eurodollar market,
which I'll address later, as well as term money market rates.
Avoiding unintended effects on the structure of the financial system
A second lens for evaluating the operational framework is the extent to which it avoids creating
incentives that might result in undesirable changes in the structure of the financial system. This
means that the framework shouldn't have lasting unintended effects on how people invest their
money or on how financial institutions interact with each other.
The Federal Reserve is operating the ON RRP on a temporary basis, primarily because the
balance sheet is currently large. The FOMC's policy normalization principles and plans make
the temporary nature of the ON RRP clear by stating that it will be discontinued when it is no
longer needed to help control the federal funds rate.26 This intention was noted again in the
minutes to the January FOMC meeting. As a result, we expect that firms would not make
structural changes in how they operate in response to the ON RRP, to avoid the cost of
unwinding those changes when it is discontinued. The intention of the FOMC to impose an
aggregate cap on the ON RRP, as described in the January minutes, will mitigate this risk.
We closely monitor industry structure and fund flows to detect whether the framework is having
any unintended impact. For example, we watch banking data and money fund holdings to see
if savings are shifting between the two, because if such a shift had to reverse as we wound
down the ON RRP, those flows could potentially create costs to the firms concerned and also
unnecessary problems for market functioning. We also keep track of prime money funds
converting into government-only money funds, because if they do so on the mistaken
impression that the Federal Reserve would provide a risk-free investment opportunity
indefinitely and on a very large scale, they might later have to unwind that change when their
error became apparent.
Avoiding financial instability
The third lens for evaluating the framework is the extent to which the framework avoids
augmenting risks of financial instability. In particular, the framework shouldn't create a risk that,
in times of stress, money market lenders will rapidly disintermediate their usual counterparties
and come to the Federal Reserve instead, such as through the ON RRP facility.27 Of course,
flight-to-quality effects existed in financial markets long before we put the new framework into
place - what I'm referring to is a situation where the framework facilitates those effects or
makes them larger.
We address the risk of sudden surges in take-up in a couple of ways. For example, we can
employ vigilant market monitoring to detect any such shifts and allow the FOMC to formulate
a response. We also use per-counterparty caps, and can use an aggregate cap.
Evidence to date on control
Now, let's discuss what the data tell us about how well the framework performed.
The distribution of traded rates in the federal funds market, shown in Figure 1, essentially made
a parallel shift higher after liftoff. These data are drawn from the new FR 2420 data collection
I discussed earlier, and they show an average over all days from liftoff to this past Wednesday,
leaving out December 31. Nearly all trading occurred within the new range - it's normal for
there to be a little bit above the range - suggesting that our framework was broadly effective
in moving traded rates upward.
Because traded rates moved upward in this way, we have so far achieved an excellent level
of control over the federal funds rate. Since December 17, the day after the FOMC meeting,
the effective federal funds rate, calculated under its current methodology as a volume-weighted
mean, has traded within the FOMC's new 25-to-50-basis-point range on all but one day, which
I'll come back to. This is shown in Figure 2. The rate has averaged around 36 basis points,
about 25 basis points above its average level over the analogous year-ago period, when the
target range was zero to 25 basis points.
Let's consider the calculation of the effective rate for a moment. Last year, we announced
some changes to that calculation, the most significant of which is that, starting in March, we
will switch to calculating it as a volume-weighted median using data drawn from the
FR 2420 data collection, rather than a volume-weighed mean using data provided by federal
funds brokers. The change in the data source was made to make the calculation process more
robust.28 We changed the calculation methodology because, while the mean and median are
usually very close to one another, when they differ the median is a better reflection of money
market activity, and because using a median enhances the reliability and integrity of the rate.29
The New York Fed published a technical note this past July that describes in detail the benefits
of this change.30
Our recent experience has confirmed the expectation that the transition to the median in March
will result in little overall impact on the level of the effective rate over time. Figure 3 shows a
time series of the mean and median rates computed from the FR 2420 data. As you can see,
they remain quite close to one another.
The FR 2420 data also allow us to examine closely the distribution of traded rates in the
overnight Eurodollar deposit market. For those who are not native speakers of money market
jargon, the federal funds and Eurodollar deposit markets are very similar: They are wholesale
funds taken in by banks, with definitional differences that I'll leave to the footnotes to my
speech.31 Just this past October, following amendments to the FR 2420 collection, we began
to receive trade-level data for the bulk of activity in the Eurodollar market.32
The Eurodollar market is considerably larger than the federal funds market. According to FR
2420 data, on average in the last two months of 2015 there was $233 billion of overnight
borrowing in the Eurodollar market; in contrast, over that same period, there was $70 billion
overnight borrowing in the federal funds market.33 I'll show some data on the composition of
activity in these markets a bit later, but it's worthwhile noting that many of the Desk's nonbank
counterparties, such as the money funds, are active lenders in the Eurodollar market.
We observed a similar response in yields in the Eurodollar market as we did in the federal
funds market, with the distribution of traded rates making a parallel shift upward of about
25 basis points, as shown in Figure 4. Since liftoff, the overnight Eurodollar volume-weighted
mean rate as calculated from FR 2420 data, as seen in Figure 5, has averaged about 35 basis
points.34 This is in line with the effective federal funds rate. The volume-weighted median, also
shown in the figure, moved upward by a like amount. This is an encouraging development
because it indicates that, as we have moved up from the zero lower bound, money market
rates are continuing to move together.
We can look into that further by examining the overnight Treasury repo market. Rates on these
transactions as reported by the tri-party clearing banks, shown in Figure 6, exhibited a similar
shift upward, although they settled modestly lower in the target range than they had in the
preliftoff period. In part, this shift likely reflects the fact that the ON RRP offered rate was 5 basis
points before liftoff - that is, 5 basis points above the bottom of the target range - and it is now
set to 25 basis points, or the bottom of the target range.
It also looks as though the increase in the federal funds rate passed through effectively into
term money market instruments. Figure 7 shows the recent progression of rates on
threemonth Treasury bills and three-month commercial paper. Also shown for comparison is a
threemonth overnight index swap quote for the effective federal funds rate. All of these rates rose
going into the December FOMC meeting, which makes quite a bit of sense, given that most
market participants expected the FOMC to tighten policy at that meeting.35 We also gather
information about rates on term unsecured borrowing in our FR 2420 collection, and about
term secured transactions from the clearing banks, and these data tell a similar story.
Treasury bill yields rose a bit less than other rates on instruments of comparable term and now
trade at yields somewhat below the ON RRP rate. Treasury bills have some attractive qualities
in comparison to ON RRP, such as round-the-clock liquidity. In addition, there seems to be
strong demand for bills from investors who don't have direct access to the ON RRP or IOR,
and it appears that most Treasury bills are owned by such investors. Also, bills have typically
traded below other money market rates during tightening cycles, as they do now; periods
where bills trade at or above other rates have been the exception and not the rule.36 Thus, the
smaller increase in bill yields than in rates on other term instruments is not surprising, and I do
not read it as undermining the general conclusion that the policy rate increase was effective in
firming money market conditions.37
December 31
Now, I mentioned earlier that fed funds traded within the target range on all but one day. Let's
talk about that day, which was December 31.
On that day, the effective federal funds rate, calculated as a mean from the FR 2420 data,
printed at 20 basis points, 15 basis points below its prior-day value and 5 basis points below
the FOMC's target range. The median dropped a bit more, by 20 basis points to a level of
15 basis points. In addition, as shown in Figures 8 and 9, the dispersion of traded overnight
rates in federal funds and Eurodollars increased on that day, with a substantial amount of
trading activity at fairly low rates. These year-end effects were transitory, and the level and
distribution of rates in the federal funds and Eurodollar markets returned to pre-year-end
conditions on the following day.
Although the effects were transitory and did not adversely affect policy implementation,
spending a bit more time on this episode can contribute to our understanding of money market
relationships. Why did we see the year-end drop in unsecured rates? Recall that the framework
functions by creating opportunities for investors to borrow funds in money markets to earn IOR
whenever there are significant differences between market rates and the IOR rate. On
quarterends, the actual and perceived marginal balance sheet costs of a number of depository
institutions increase as they publish financial statements and calculate regulatory ratios.38
These increased balance sheet costs mean that depository institutions borrowing funds in
money markets to earn IOR must do so at a lower interest rate to account for these costs.
Further, the reduction in balance sheet capacity can temporarily lower the bargaining power of
lenders, again allowing borrowers to obtain funds at lower rates.
Many lenders in the federal funds and Eurodollar markets with access to the ON RRP facility
responded to these low rates by increasing their use of the facility, as shown in Figure 10.
However, other lenders remained in these markets, including those without ON RRP access,
those who received funds late in the afternoon after the ON RRP operation had already
occurred, and those for which the ON RRP was not an acceptable substitute. On this last point,
for some institutions, the ON RRP is an imperfect substitute to lending in private unsecured
markets because, in the tri-party repo system through which the ON RRP is settled, cash is
not returned at maturity until late the next day, whereas in private unsecured markets, earlier
return of funds can be negotiated.39
These quarter-end effects, as measured by the effective federal funds rate, are likely to appear
a bit larger when we switch in early March to a median calculation. As I mentioned, on
December 31, the median fell a bit more than the mean did, 20 basis points in the median
versus 15 for the mean. A larger relative decline isn't unusual; averaging across the
quarterend dates in March, June, and September 2015, the median declined by 7 basis points while
the mean declined by 6. The median declines more because it is, in most cases, a better
measure of the center of the distribution of traded rates - an issue the Desk analyzed at some
length in the technical note I mentioned earlier. This difference between the two might grow a
bit more as rates move further from zero.
In secured markets, rates in the tri-party repo market on year-end were relatively stable. This
makes sense, as ON RRP is a good substitute for tri-party repo with private counterparties,
and therefore this facility forms a fairly firm floor on overnight repo rates for lenders that have
access to the facility.40 As I'll show in a moment, volumes declined in the private repo market,
as is typical on quarter-ends.
Evidence to date on other "lenses"
Turning to the second lens I noted earlier, we have achieved excellent control while avoiding
any unintended change in the structure of the financial system. Figure 11 shows RRP take-up
over time, grouped by counterparty type. Take-up, both in aggregate and at the
counterpartytype level, has been stable since liftoff. Among the money funds shown in this figure,
government-only funds make up more of the demand on typical days, with funds that can invest
in a broader universe of money market instruments, called prime funds, accounting for the
balance. This has also been stable since liftoff.41 Indeed, more recently, usage has come down
as unsecured and secured rates have firmed some. Even with zero usage, the ON RRP facility
could still be effective in underpinning the level for money market rates by supporting lenders'
bargaining power.
In addition, as shown in Figure 12, lending volumes in secured and unsecured money markets
have been stable, suggesting that the Federal Reserve's facilities have not displaced activity
in the private sector.42 Figure 13 shows activity in unsecured markets by select lender types.
This shows that, post-liftoff, the composition of activity in these markets also appears to have
been stable.
Finally, I'd like to speak briefly to the third lens, avoiding financial instability. As you know, there
has been quite a bit of volatility and risk aversion in financial markets lately, and there has
been no corresponding surge in ON RRP demand. This continues to be an issue that the
FOMC is thinking closely about, as reflected in the January FOMC minutes.
Lessons learned on operational structure
We have learned a lot about the structure of our operations from our experience with liftoff. I
will discuss a few of my observations.
Let's begin with quantifying the aggregate capacity limit. At the December meeting, the FOMC
directed that the ON RRP's capacity be "limited only by the value of Treasury securities held
outright in the System Open Market Account that are available for such operations." As a result,
in practice, the ON RRP is currently being run with an aggregate capacity limit of around $2
trillion, which is far in excess of typical daily demand and well above the $300 billion capacity
limit the facility had had since September 2014. As the FOMC made clear in the minutes to its
March 2015 meeting, this elevated capacity was intended to ensure a smooth liftoff, but the
absence of an aggregate cap is only temporary. This is why the recent January minutes
included a discussion of when and how it will be appropriate to reinstate an aggregate cap.
So, what have we learned about the appropriate level of the cap? It seems likely that having a
very elevated aggregate capacity was helpful in controlling market rates initially, perhaps
because it showed the FOMC's commitment to achieving interest rate control, but it's unclear
exactly how much available capacity, or "headroom," is needed to maintain such control. By
way of background, determining the appropriate level of capacity involves striking a balance
between the "lenses" I discussed earlier. Imposing a limit on the facility's capacity reduces the
extent to which there can be a disruptive surge of funds into the facility and the extent to which
private-sector investors can change their lending patterns by using the facility. Thus, such a
limit helps avoid financial instability and unintended effects on the structure of the financial
system. However, a limit that is perceived as likely to bind weakens our control of interest rates,
because when demand exceeds capacity, the interest rate paid on the ON RRP facility is
determined by an auction and is likely to be below the offering rate, thus reducing the efficacy
of the facility in supporting the federal funds rate.43
Our recent experience suggests that having reasonably high aggregate capacity can help
improve control without necessarily encouraging greater use of the facility. When that capacity
is great enough, money market lenders are confident that they will be able to place funds with
us at the administered rate, even on financial statement reporting dates. That confidence
empowers them to demand rates from their borrowers that are above the ON RRP offering
rate. Conver