The Fed would like the ON RRP to play a bigger role in its rate control framework, but the ON RRP has been and will always be a very leaky floor for money market rates. From 2016 to early 2018, Treasury bills and agency discount notes consistently traded several basis points below the ON RRP. Today, even tri-party GC repo is occasionally dipping below the floor. The floor will only get leakier as money floods into the front end: QE continues to pour $120b a month into the banking system, the TGA continues to decline, and banks continue to shed low quality deposits. In this post we review how the ON RRP transmits policy rates, why the global nature of the dollar system means it will always be a leaky floor, and why even a ON RRP rate adjustment may not protect the 0 percent lower bound.
How Does the ON RRP Floor Work?
The ON RRP offers certain counterparties (banks, 2a-7 MMFs, GSEs and primary dealers) the option of placing money at the Fed (via tri-party repo) at the ON RRP offering rate. This gives ON RRP counterparties bargaining power such that they never have to invest at rates lower than the ON RRP offering rate. In practice, the vast majority of ON RRP usage is done by MMFs, who have $4.5 trillion in assets. That enormous pool of capital is the mechanism through which Fed policy is transmitted in the money markets. Any money market instrument must yield more (or equal) than the ON RRP offering rate, or the MMF will not invest in it. For the most part it works well, yet there are also extended periods of time when certain money market rates trade below the ON RRP floor. This is because there are many USD investors who are not eligible to be ON RRP counterparties.
Note that the Fed funds rate will never trade below the ON RRP rate as all lenders in that market have access to the ON RRP. But Fed funds has been irrelevant to the transmission of monetary policy for over a decade (like a flatlined EKG, it prints at the same rate every day). What is the point of keeping Fed funds above the 0 percent floor when other money rates fall below the floor?
Dollar Cash Pools are Both Vast and Global
The ON RRP has never been a floor for USD money market rates because vast pools of dollars don’t have ON RRP access. Domestically, there are state and local governments (they lend around $200b in repo), private liquidity funds (~300b in assets), Treasury only 2a-7 investors that cannot invest in repo, as well as pockets of cash held by pensions and corporations. But more importantly, overseas dollar holders cannot access the ON RRP.
The dollar is a global currency used in trade and investment around the world, even when there is no U.S. connection. Foreign banks around the world serve their clients by taking dollar deposits and making dollar loans. The BIS notes that foreign banks have around $5 trillion in USD deposits booked outside the U.S. The Fed recognizes the importance of this global system through its FX swap lines, implicitly backstopping the off-shore dollar banking system much like the Discount Window backs backstops the domestic banking system. These facilities essentially create a ceiling on global USD money market rates.
However, there is no global version of the domestic ON RRP to maintain a floor on global dollar rates. Foreign investors and foreign corporations have dollar liquidity they need to manage, but do not have the same tools available to domestic investors. There are off-shore USD money funds (often domiciled in Ireland or Luxembourg) to help foreigners manage their USD cash, but those funds do not have ON RRP access. In addition, many smaller foreign banks do not even have a Fed account to receive IOR, thus raising their costs and reducing their willingness to offer positive USD deposit rates (smaller foreign banks rely on correspondent banking). Excess dollars within the the U.S. can ultimately flow into the ON RRP, but excess dollars held abroad have more limited options.
The regulatory forces driving liquidity out of the U.S. banking system operate abroad as well. Basel III is a global standard, so banks around the world are subject to leverage and liquidity constraints that incentivize them to shed low quality deposits. At same time, QE is a global policy response that will continue to balloon bank balance sheets for the foreseeable future. Foreign banks may have more balance sheet capacity than domestic banks, but that is changing as well.
The dollar liquidity held by world’s non-ON RRP counterparties can try to get into a MMF with ON RRP access, but MMFs are already operating at a loss and may soon have negative net yields (MMFs could also simply refuse new investors). There is no where to go. These investors will be forced to invest at rates below the ON RRP offering rate, just like prior to 2018. (Note: foreign official accounts are safe as they have access to the Foreign RP pool)
ON RRP Hikes May Not Work
There is a strong relationship positive between ON RRP hikes and money market rates, but it is not a perfect relationship. Raising the ON RRP rate will push all money market rates up, but the increase does not pass through 100% (except in the zombie Fed funds market). This is even true in the overnight tri-party market, as rates as a spread to the ON RRP offering rate fluctuate. An ON RRP rate hike would lift all money market rates, but its not clear if the passthrough would be enough to avoid negative rates unless the hike was sizable(for the mechanics of this, see this post).
In Q1 2018, Treasury issued net $300 billion in bills and that demand for money pushed all money market rates comfortably above the ON RRP floor. Treasury bills are the ultimate foundation for dollar money market rates as they are liquid, credit risk free, and accessible to all investors. The only way to keep money market rates above the 0 percent bound is for Treasury to issue more bills. Our fiscal trajectory suggests that will not be a problem, but politics are unpredictable and the road will be bumpy. Money market rates will move higher when bill issuance picks up, but that may be after the market shows that Fed the weaknesses of its current tools.