The hullabaloo in the repo market torpedoed the function of Interest on Excess Reserves and forced the Fed to go back to the future.
With its announcement this morning, the New York Fed confirmed that the Fed’s Plan A of manipulating the federal funds rate into its target range – now between 1.75% and 2.0% — has miserably failed, and that it will switch to Plan B to control short-term interest rates. But this Plan B used to be Plan A that the Fed had routinely deployed to control short-term interest rates before the Financial Crisis. So back to the future.
The “repo operations” the New York Fed has been conducting since Tuesday were overnight repurchase agreements (ultra-short-term loans), where in the morning, the New York Fed offers up to $75 billion in cash at an interest rate that is within the Fed’s target range. These loans are secured by collateral. The allowed collateral are Treasury securities, Agency securities, and mortgage-backed securities guaranteed by the Government Sponsored Enterprises (GSEs).
These overnight interest-bearing loans unwind the next morning, with the Fed getting its $75 billion in cash back, and the dealers getting their collateral back. As these operations were undertaken every day for the past four days, it’s essentially the same $75 billion that gets recycled every day. The daily amounts are not additive. And these operations have nothing to do with QE.
Back in the day, the New York Fed used to conduct these repo operations routinely. But in September 2008, when Lehman and AIG collapsed, the Fed switched from repo operations to emergency bailout loans, zero-interest-rate policy (ZIRP), QE, and other tricks and devices. Repos were no longer needed to control rates.
The chart below shows the tail-end of the era of repo operations through 2008. The spike in repo operations following September 11, 2001, occurred when the Fed briefly injected massive amounts of cash via repos, as funding had dried up, and short-term rates were blowing out: