The politics of the Fed’s reverse repo mechanism

There has been a lot of talk about the Federal Reserve’s Overnight Reverse Repurchase (ONRRP, RRP, or reverse repo) mechanism.  The Fed has chosen to expand the limits on this program (to now only be limited by the amount of Treasuries the Fed has available as collateral) and its use of the mechanism in order to raise the federal funds rate (FFR) to within its new target.  Some have expressed concerns that the Fed should have resorted to its more ‘conventional’ policy tool for raising the FFR—simply selling its Treasurys.

The concerns over using the reverse repo tool instead are reasonable.  There are restrictions placed on the re-usage of collateral that a firm entered into an RRP is temporarily holding—limits that don’t apply to owned Treasuries; RRP Treasuries can’t be reused in other financial transactions as margin, a deliverable on a short position, etc. so the financial system can’t function as smoothly as a situation in which the Treasuries had been sold into private hands.  Further, by using the RRP facility instead of selling the Treasuries, the Fed becomes a ‘player’ in the market and thus could displace some necessary liquidity for banks.

While that may be, the choice to use the ONRRP to set the fed funds rate floor will serve to improve market functioning in the case of a downturn.  Last week’s rate hike for the first time in nine years was by no means a cut-and-dry decision.  If the downside risks materialize and the economy/markets turn sour, the Fed will be able to reverse course much more easily given that it has chosen to retain its accommodative $4.5 trillion balance sheet instead of selling off to raise the FFR.  If growth/inflation/wage growth slow, the Fed won’t need the political capital that would be necessary for a “QE4” or some other unconventional measure.  This is especially important in a time of recently increased regulations over the Fed and an election filled with candidates calling for even more.

The Fed has learned from 2008 what can happen when it lacks but needs political capital to make a decision crucial to the functioning of the U.S. economy—a situation it won’t let itself acquiesce to again, especially in today’s fragile global economy and political uncertainty.  The Federal Reserve is keeping its massive balance sheet as political insurance.


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