Chapter 2 In The RRP Fairy Tale

ABOOK Jan 2016 Desperate China CNY2

SABOOK Jan 2016 Dollar Repo China2

The problem is that these money markets are acting individually without any kind of active participation which would (and should, if the FOMC is to be believed) solve, via arbitrage, just these sorts of irregularities. That clearly hasn’t happened, and repo fails (along with shallow T-bill rates) prove that repo is utterly distinct from that process. There is no active intermediation that is bridging these divides in collateral let alone raw money market flow.

That, too, is a problem I foresaw going all the way back to when the RRP was first announced in this context in September 2013:

It [the theoretical design of the RRP] would also provide a channel for collateral to flow into the marketplace at the Fed’s discretion. Since non-banks and banks alike can bid for however much they wish at these reverse repo auctions (full allotment), they would then possess enough (theoretically) collateral to satisfy market demand. In other words, the Fed controls the margins of the US treasuries in its balance sheet inventory so that collateral is “priced” not to yield negative rates, or even below the IOER or whatever policy target it seeks. Right now, since the effective federal funds and the GC repo rates trade below the IOER floor, owing to the presence of non-banks, this would be a means to enforce further control over short-term rates and make the IOER floor an actual policy framework like the ECB “corridor”.

 

I am not as sanguine as some about how that might work, particularly in a climate of rising fear, but it does offer the possibility of using the SOMA holdings to alleviate a “market” collateral shortage.

 

The weak link here is that the entire plan is dependent on the Fed being correct in its perceptions of market conditions and that it can tailor its response to actual functions. It would still be dependent on non-market, bureaucratic decisions, the kind made during the months of tension before actual panic in 2008. It would also introduce an additional collateral “rental” fee that might not be calibrated correctly. In short, this plan depends on the Fed to correctly surmise rough patches and their causes, and then correctly deal with them in effective doses of policy. I don’t see what confidence that inspires.

Again, we are way past concerns about the Fed controlling interest rates on their way to fulfilling normalcy; these are testaments to the huge and vital gap between monetary theory and monetary practice under increasingly strained existence. So much of what liquidity that remains is predicated on the idea that the central bank will be able to provide “elasticity” should it ever be truly necessary (again). Money markets, and repo fails in particular, show without any doubt that monetary policy cannot, and that it doesn’t know what it is doing – at all. This wouldn’t be suitable for 2007 (which was the entire point; legislating the last crisis) let alone 2016.

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