One more post on the FOMC statement as I think it is vitally important in the context of financial function. I already covered the economic end of it, which is comparatively undesirable itself, but the only mention of repo in the statement was in reference to the assumed high degree of effectiveness of the reverse repo/IOER “floor” the Fed has created.

Most participants agreed that adjustments in the rate of interest on excess reserves (IOER) should play a central role during the normalization process. It was generally agreed that an ON RRP facility with an interest rate set below the IOER rate could play a useful supporting role by helping to firm the floor under money market interest rates. One participant thought that the ON RRP rate would be the more effective policy tool during normalization in light of the wider variety of counterparties eligible to participate in ON RRP operations. The appropriate size of the spread between the IOER and ON RRP rates was discussed, with many participants judging that a relatively wide spread–perhaps near or above the current level of 20 basis points–would support trading in the federal funds market and provide adequate control over market interest rates.

Clearly the committee members are very much enamored with their new policy tool (toy?). Where they failed to enforce a floor during the worst days of the panic in 2008 and into 2009, due in no small part to the quirks of the US interbank system, there is much confidence here that flaws have been found and addressed positively.

That is one reason why the recent spike in repo failures is important. The reverse repo program is supposed to directly alleviate a collateral shortage of this kind. A major shortage might, after all, push money rates below where the Fed set its “floor.” To lose control of short-term rates, again, during an anomaly would be potentially dangerous, especially if it were to take place during “normalization” where instability would be beyond elevated.

The current failures problem directly rebukes the idea that the Fed has all possible adverse scenarios covered. To do so would necessarily mean that FRBNY’s SOMA portfolio has to maintain a broad enough inventory to satisfy whatever the “market” may be most in need of. That is, on its face, a patently unrealistic assumption since it will be impossible to predict exactly what repo markets need in even the immediate future, let alone during any drawn out “normalization.” And that is exactly what is taking place at this moment (or at least a week or so ago – we don’t know what the fails are yet for this week).

As with all things central banking, there is a measurement problem to go along with an unhealthy dependence on theory; or exactly the weakness I laid out when the reverse repo program was first introduced:

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.

This severely, in my opinion, undermines the credibility of even the idea of the rate floor. That may not sound like a big deal, but again in terms of liquidity, credibility is vitally important, especially the credible indication of a ready and usable supply of collateral to maintain funded positions, particularly dealer balance sheet capacity. That gets portioned out further as it relates directly to the daisy chain of rehypothecation, where a minor disruption is amplified.

Supposedly the Fed’s staff is working on these issues, though we don’t know specifically if it relates to the notion of the floor, and how this might interplay with an incrementally rising IOER. There are so many moving parts and variables (which defines, technically, a complex system that is beyond the comprehension of linear statistics) to even begin to assume such clarity is seemingly imprudent (though you can understand the need, from the FOMC’s perspective, to maintain the idea of calm and order). However, whatever may be taking place behind closed doors in DC and NYC, there was, again, absolutely no mention of the repo markets (outside the carefully glowing description of the reverse repo program) in the statement today. None.

The FOMC wants, actually needs, to instill confidence that it can transform itself from its QE legacy (however much tarnished it has grown). Last year’s selloff in bond markets and global dollar funding was not a good start in that direction. A strong position and confidence of these “toys” would acknowledge their possible flaws, particularly as they are so obvious at this moment. This only heightens the idea that stability is a paperlike illusion that may be undone with only the slightest “shock” or disruption – the hidden asymmetry that is the hallmark of fragility.


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