Commentary: First Week Under the New Monetary Regime

It's the week of Christmas, but it's also the first week of a very new monetary framework in the United States.  When Federal Reserve hiked interest rates last week, it implemented it's policy change in a very unique manner.  Rather than selling Treasury securities into the market to drain liquidity out of the financial system, the Fed raised interest rates it pays on reserves. The Fed will pay 25 basis points to institutions which engage in reverse repurchase agreements (RRP) with the central bank, and 50 basis points on excess reserves. The idea is that the Fed is trying to set an effective price floor in the 25-50 basis point range.  The Fed is taking this new approach because the system is so awash in liquidity that it would need to unload trillions of securities in order to get short term interest rates up.  This would risk destabilizing the bond markets and send longer term interest rates soaring. 


In assessing the effectiveness of the Fed's new policy, it is critical examine the behavior of short term interest rates.  This will allow us to gauge the firmness of the Fed's newly constructed price floor.


Libor and Effective Fed Funds Rates have Fixed Higher:


Both libor for USD and the effective Fed funds rates have fixed around 36 basis points since the Fed moved.  However, it is dangerous to put to much stock in these figures, since again, given that the system is still full of liquidity from  QE, banks have no need to trade Federal Funds anymore.  Volumes on this market are therefore miniscule, and not reflective of actual overnight rates.


Overnight Repo Rates are also Higher:


According the DTCC Overnight Repo Index , repo rates for Treasurys and Agency MBS/debentures have go up in the past week to settled around 30 basis points.  Volumes on this market are much higher (about 150 billion daily), and thus a more accurate measure overnight rates.  Earlier this year, most repos were trading around 15 basis points. The Fed seems to have succeeded in getting this interest rate, which financial institutions actually borrow at, to rise slightly. 
Oddly, Short-Term Treasury Rates Haven't Budged:
The US Treasury auctioned off 4-week bills at a 19 basis point yield on Tuesday, a basis point lower than a week ago, and well below the Fed's 25 basis point RRP floor.  While traditionally the US government has been able to borrow below short term money market rates, this has long been assumed to be a reflection of the small amount of counter-party risk entailed in overnight lending.  Indeed, lending the fact that parking your money with Uncle Sam is safer than investing it in a money market mutual fund was all to evident seven years ago.  However, this time, the counter party for the new RRP is the Federal Reserve System, a branch of the US Government itself.  The only explanation can be that firms with money to invest cannot access the RRP and are thus forced to invest in short term Treasurys.  


In sum, the Fed has gotten money market rates up a bit, but holes exist in the rate corridor it has built.  A much, much cleaner solution would be for Congress to grant the Fed authority to pay interest on reserves to any and all takers (not just banks).  This would allow the Fed to set a unified, and single rate which would act as a much firmer price floor on the money markets than today's two tiered system.