Interest Rates, ‘Reverse Repos,’ and Liquidity Risk – What Happens When The Fed’s Bond Buying Ends?

MarketsAccording to a recent Wall Street Journal blog, here, the President of the Federal Reserve Bank of San Francisco, John Williams, says it will be another year before the Fed begins raising interest rates.  If the definition of “news” is “something new” this observation is not “news.”  Nevertheless, the article is newsworthy in one sense – it confirms pretty much what mainstream economists and the Fed have been saying for some time. To that extent, its consistency is newsworthy.  Here is a thumbnail of what appears to be the general economic consensus regarding interest rates today:

  • “Everything depends on what happens….” That is, “…absent some major shock to the economy….”  Obviously, most forecasts must be conjoined with caveats.
  • He expects rates to be raised “gradually.”
  • He forecasts that the Fed will wind down its bond buying, i.e. “Quantitative Easing” [1] this year.
  • He noted what everyone who stepped outdoors this winter already knew, that due to the harsh weather, “…the economy got off to a ‘bad’ start….”
  • “(H)e sees a pick-up in growth and expects that the economy will likely grow around 2.5% this year.”
  • Like any sentient being watching the kabuki dance going on in Washington, he “…lamented the performance of Congress, which he said was acting like a brake on growth the Fed cannot overcome with its aggressive stimulus policies.”

Perhaps the “newest” piece of “news” in this article was the reference to an arcane sounding arrow in the Fed’s quiver they have recently taken out for beta testing:  It’s called, “overnight reverse repurchase agreements” or “reverse repos”.[2] The Fed has taken pains to say that it’s not a change of monetary policy, but merely “prudent planning.”   For a detailed discussion of reverse repos, see its FAQs here.  Apparently, the Fed has been testing the program for the last several months, and according to Mr. Williams, it has “gone well.”

Mr. Williams said the tests have been “very successful” and added “I think there should be a role for this” in the future. But he also said he’s unready to say whether the central bank needs to overhaul its traditional method of moving short-term interest rates by intervening in the market to influence what’s called the fed funds target rate, which the Fed currently pegs at between 0% and 25 basis points.

The Take-Away.  To my knowledge, there were few references to the reverse repo program in the business news before the Fed began to take its foot off the QE pedal, late last year.  This is not to say they hadn’t discussed it – they had.

But besides interest rates, there is another big concern: Once the Fed has completed the QE program, it will have a very large balance sheet of bonds [$85B/month in 2013], while the banks’ holdings will be at “historic” lows.  This creates the kind of liquidity risk that caused the collapse of the credit markets in 2008.  Ergo, once the Fed completes its EQ later this year, it wants to have a Plan B in place to deal with the consequences of holding all of the bonds it purchased from the Big Banks and to deal with potential liquidity risk.

According to a Forbes article earlier this year:

Now, the Securities and Exchange Commission is worried that a bond market decline, even one that’s far smaller than the carnage of 2008, could hurt investors more than similar events in the past. Its Division of Investment Management recently published a paper that explains how liquidity risk could be a growing problem because the amount of bonds that banks now hold in their inventories is at a historic low.

Hmmm. The last six months of this year, especially in the lead-up to the mid-term elections, should be interesting.  Is it possible the politicians [including those in the Executive Branch] will actually have to start focusing on the economy rather than casting stones at each other’s glass houses?

[1] I have discussed Quantitative Easing (“QE”) here.  Essentially, for the past several years, the Federal Reserve has engaged in a program of buying billions of bonds a month from Big Banks, thus replacing their holdings with cash. The hope being that this would keep interest rates low, encourage capital investment, improve employment, and generally kick-start our economy.  It did keep interest rates low, but the other results have been slow and disappointing.  Perhaps the most devastating result of QE is that it destroyed the growth of fixed-income retirees’ saving.

[2] A “reverse repo”  is an arrangement whereby the New York Fed sells a security to an eligible buyer [aka “counterparty” such as a big bank] with an agreement to repurchase it “…at a specified price at a specific time in the future.”  Thus, New York Fed trading desk receives cash from the counterparty in the first instance, and then repurchases the security for cash at the agreed-upon time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, “implies” a rate of interest paid by the Fed on the cash invested by the counterparty.  This implied interest rate “…the Fed pays on the transaction should, it is hoped, set a floor underneath short-term interest rates. The reverse repos could help the Fed raise short-term interest rates without having to take active measures to shrink its very large balance sheet.” When the Fed engages in reverse repos on an overnight basis, the program is called an “overnight reverse repo.” See discussion here.