By initiating the tapering of the Federal Reserve's quantitative easing program, former chairman Ben Bernanke left office knowing he had set in motion the process that would ultimately wind down the Federal Reserve's massive balance sheet and return to more normal times.
But the taper won’t be Bernanke’s only legacy in terms of reversing the stimulus measures he undertook in trying to counteract the Great Recession.
He also oversaw, starting in summer 2011 when the central bank first sketched out its exit strategy, the creation of a new Fed tool for raising rates that will represent a new chapter in U.S. central banking, when it comes into play a few years from now.
The tool is known as the fixed-rate, full-allotment overnight reverse repo facility, or RRP.
It sounds complicated, and it is. But if all goes to plan, this monetary doomsday device will play a leading role in the Fed’s interest rate policies in the years ahead.
The RRP is a solution to a problem the Fed will soon face: how to unload its massively inflated holdings of bonds once the economy finally picks up.
If it acts too late in unloading its massive holdings, it could spark high inflation. But it can’t sell off its trillions in Treasury bonds and mortgage-backed securities quickly without wreaking havoc in financial markets.
It’s no small problem. The Fed’s balance sheet will likely eclipse $4.5 trillion by the time its monthly bond purchases are tapered to zero — an unprecedented situation fraught with uncertainty.
The Fed has said that only after it has raised short-term rates will it decide between selling off its trillions in Treasurys or holding them to maturity.
But that’s where things get tricky: In normal times, the Fed raises short-term interest rates by selling bonds to banks, thereby taking banks’ money out of the system and driving up the price — the interest rate — of the overnight loans banks make to each other to meet the Fed’s reserve requirements.
But times aren’t normal when the Fed has $4.5 trillion-plus in assets, and banks are holding more than $2.5 trillion in excess reserves at the Fed, where they earn a 0.25 percent interest rate. To manipulate its normal target rate, the rate for overnight reserves, the Fed would first have to sell $2.5 trillion in bonds, which isn’t realistic – doing so would threaten the financial system.
Enter the RRP.
Fed Chairwoman Janet Yellen tried to explain the RRP to Sen. Kay Hagan, D-N.C., at a hearing in late February. The program, she said, “is one where we're essentially borrowing from … entities other than banking organizations, we're offering to pay a low fixed rate and are offering our counterparties in return for the loans to us, collateral.”
The interest rate on those overnight transactions with nonbank financial businesses will allow the Fed to control short-term interest rates in a “very smooth way” when the time comes, Yellen said.
Here’s how it works: The New York Fed sets a target interest rate — the “fixed rate.” Then it offers to sell securities to eligible counterparties with an agreement to repurchase that same security the next day at a price determined by the target interest rate — the “reverse repo.” And, ultimately, it will make as many of these deals for as much money as any businesses want — the “full allotment.”
Those companies the Fed trades with are nonbank financial institutions, such as money market mutual funds and government-sponsored enterprises like Fannie Mae and Freddie Mac. They are interested in trading with the Fed because they have excess funds on any given day to lend out on a short-term basis and earn interest.
For now, the allotment is still limited, but the amounts will likely be quite large ultimately, as the market for repossessions between nonbanks such as money market mutual funds is now larger than the market for overnight reserves between banks.
The New York Fed has been testing the RRP for months. In recent days, the Fed has transacted with between 40 and 70 trading partners for amounts ranging from $55 billion to $130 billion.
Whatever rate the Fed offers through the RRP sets the floor for all interest rates in the economy. As former Fed staff economists Joe Gagnon and Brian Sack explained in a recent paper for the Peterson Institute for International Economics, lenders “would not be willing to provide funds on an overnight basis to other counterparties for a lower yield than they could obtain at the Fed's RRP facility, given that the latter is free of counterparty risk.”
“In a nutshell, it’s a way for the Fed to force the front end of the market to trade at higher and higher levels,” said Joe Lynagh, who manages money market funds for T. Rowe Price.
Lynagh said the early success of the RRP "speaks to the demand for high-quality investments" among mutual funds, which can profit from making risk-free loans to the Fed on a short-term basis.
For now, each counterparty is limited to loaning the Fed $7 billion in each transaction. But in a year or so when the Fed wants to start raising interest rates, it will lift the cap, and allow a “full allotment” from any counterparty.
At that point, said Lynagh, when “I can get all I want from the Fed as the ultimate counterparty,” all other borrowers will have to match the rate paid by the Fed.
The RRP is not the only tool the Fed will lean on to raise rates. Yellen has noted that the bank also plans to use the interest rate it pays on excess reserves held at the Fed to set short-term rates.
But for a number of technical reasons, including the fact that Fannie and Freddie can't earn interest on excess reserves held at the Fed, the RRP is the tool the Fed now seems to prefer. The RRP also addresses other problems the Fed faces.
It could be years between the time when the Fed begins raising rates and when it shrinks its balance sheet to a normal size — if ever, according to Gagnon and Sack. In the meantime, the RRP, little known now, will be the way monetary policy is done.