Money Market Turmoil.

• Date: 01 January 2020
• Author: Malz, Allan M.

The federal funds rate is the unsecured overnight rate at which banks lend to one another in the domestic U.S. market. For several years after the Fed implemented its crisis-era approach to operations, it wrestled with a soggy federal funds market: the Fed's response to the crisis had made it difficult to keep the funds rate from dropping through the lower limit of its target range. With experience, and the introduction of new operational tools, the funds rate was eventually stabilized near the middle of the target range.

Beginning in 2018, however, the contrary problem emerged: the funds rate gradually approached uncomfortably close to the upper limit, raising the possibility it could breach it, evading the Fed's control. In July and September 2019, isolated such breaches actually occurred as just one sign of a severe liquidity shortage in the wholesale money markets. Sustained disruption in these markets, in which large nonfinancial firms, banks, securities dealers, and money market mutual funds can meet a transitory need for cash or invest liquid balances, poses risks to the smooth operation of other parts of the financial system and ultimately to the nonfinancial economy it supports.

The tightening in the money markets is just the most recent manifestation of the fragility and impermanence of an approach to implementing monetary policy that has been somewhat ad hoc since its initiation during the crisis. In contrast to the precrisis operating framework, the current approach is dependent at any point in time on a particular configuration of money market supply and demand. When it changes, as is inevitable in response to shifts in the markets, or to the unintended consequences of policy shifts, the Fed has also had to adjust the mechanics of how it keeps market rates near its target. An important mechanism for the transmission of monetary policy is clear signaling of central bank intentions, and the frequent changes in the operating framework work against clarity.

This article sets out how Fed operations and money markets have evolved in recent years and their implications for normalizing monetary policy and defining a new long-term operating regime. The market rigidities induced by postcrisis regulatory revisions have interacted with the changing monetary operating framework and changing market expectations to produce a succession of disruptive surprises in the money markets, most recently the large increases seen in key money market rates in September 2019.

The revised regulatory framework aims to achieve enduring financial stability and end the vulnerabilities perpetuated by an overleveraged financial system. But by relying on detailed requirements and proscriptions of specific activities rather than credibly phasing out explicit and implicit bailout guarantees, it has eroded the functioning of the money and other financial markets and created obstacles to any new or revived framework for monetary policy, while contributing only modestly to financial stability. This represents a substantial cost of the new regulations that must be set against their putative benefits, costs that might be acceptable if the regulatory approach itself did not miss its mark.

The Postcrisis Evolution of U.S. Monetary Operations

Control of short-term interest rates is the core of how the Federal Open Market Committee (FOMC) has implemented monetary policy, both before and since the crisis. It targets the market-clearing funds rate, at which banks can borrow from or lend to one another to smooth out routine and seasonal fluctuations in cash holdings and keep payment systems in balance. (1)

The funds market is part of the larger, more-or-less integrated U.S. dollar wholesale money markets. It includes overnight and short-term secured and unsecured lending between commercial banks, and between banks and other intermediaries such as dealers, institutional investors, and money market mutual funds, as well as Treasury bills. The pre- and postcrisis operating regimes both view the funds rate as an anchor for other short-term lending rates, so eroding money market integration is highly problematic. (2)

The current regime took shape during the crisis as the Fed sought to retain control of short-term rates while drastically expanding the amount of reserves. For decades prior to the crisis, the Fed got close to the desired funds rate by stating a target level for the funds rate and adding or draining the estimated amount of reserves--deposits at Federal Reserve district banks--needed to get the market to clear there. Fluctuations in the supply of and demand for reserves could be estimated with tolerable accuracy. The public's knowledge of the target rate as well as the Fed's daily operations made the framework effective in keeping the funds rate near the target, and it was robust to changes in the financial system over the decades it was in place.

But starting at the end of 2007, the Fed acquired a vast amount of assets, at first consisting of emergency loans to banks, dealers, and foreign central banks among others, and from the beginning of 2009, in even greater size, Treasury and agency mortgage-backed securities (MBS). These new assets were not a matter of normal monetary policy. The emergency loans were extended as temporary liquidity support for key markets and intermediaries. The bond purchases, carried out in a sequence of large-scale asset purchases (LSAPs) through 2014, aimed, not to influence short-term rates, which by then were loosely governed by interest on excess reserves (IOER), but to push down long-term interest rates.

The large volume of reserves issued as the liability counterpart to these assets would normally have been expected to lead to a sharp decline in the fed funds rate. To ward off the as-yet unwanted loosening of its monetary stance that could result from a massive increase in its balance sheet, (3) the Fed began in October 2008 to pay IOER, remunerating banks for holding a risk-free alternative not only to other money-market lending, but to business and household lending, making reserve balances attractive to suddenly risk-averse intermediaries during the crisis. IOER would also set a lower limit or floor on the funds rate and keep it from straying too far from the target rate. An alternative investment for banks' cash balances would have to pay at least the IOER rate, while rates on alternatives that paid more would be bid lower.

In the event, bank lending did not expand, but most banks were not as eager as expected to acquire additional reserves and earn IOER. U.S.-domiciled banks, but not foreign banking organizations (FBOs), are subject to Federal Deposit Insurance Corporation (FDIC) deposit insurance fees on all assets, including reserves. Banks in the Federal Home Loan Bank System (FHLBs) aren't eligible to earn interest on their reserves at the Fed.

So the funds market shrank drastically, with FHLBs lending their uninvested mortgage-loan proceeds to FBOs, and domestic banks content to hold a larger stock of reserves than before the crisis, but for the most part not actively bidding for more. (4) As a result, the funds rate stayed well below IOER. U.S. banks were at first not only reluctant to add additional risky loan assets to their balance sheets. They didn't even wish to add safe reserve balances on which they would earn the spread between IOER and the funds rate. Eventually, as regulatory changes introduced later on came into force, reserve balances came to be disproportionally concentrated on the balance sheets of FBOs and large U.S. banks. (5)

With IOER not fully effective as an anchor for the funds rate, the Fed began to target a range rather than a level for the funds rate, and in 2013 introduced an additional operational tool, overnight reverse repos (ON RRPs), through which it drains reserves by borrowing from a wide range of intermediaries, not just banks, at a specified rate generally equal to the lower limit of the range. ON RRPs have been used in significant volumes only sporadically.

The funds rate, with isolated exceptions, remained confined until early 2018 near the midpoint of its target range, even through the rate hikes that began at the end of 2015 (Figure 1). The use of a range, and the tendency of the funds rate to trade near its midpoint, was optically similar to the Fed's precrisis framework in permitting the funds rate to fluctuate narrowly at a desired level, and to symmetric corridor systems found in other countries. But it was also quite different in that the upper limit of the range, the level at which IOER was also set, was at least initially intended to be the lower limit. Rather than serving as a ceiling on rates, IOER was a mechanism to keep the funds rate from falling even lower, in a market awash in reserves, through an arbitrage that remained incomplete. (6)

The Recent Turmoil in the Money Markets

The turmoil that began in mid-September 2019 has been centered in the repo market, in which short-term loans are secured by high-quality bonds, generally Treasuries or MBS. Securities dealers, traders, and many investors finance holdings of Treasury securities by borrowing in the repo markets, using the bonds as collateral. Repo is a much larger market than fed funds, accounts for over half of dealers' funding, and is a major component of money market mutual fund assets. (7) Prior to the crisis, the Fed sought to control short-term rates by operating in the repo market, rather than directly in the funds market, so money market integration was central to its success in implementing policy.

The repo rate should trade at least a bit below the funds rate, as it generally did before the crisis, because repo transactions are secured, while funds trades are not. Reserves are claims on the Fed, but fed funds liabilities to other banks are just unsecured claims. In 2018, the repo rate, which in spite of being secured had generally been higher than the soggy funds...