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What The Fed’s Reverse Repo Raise Means for the Markets

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At their last meeting, the Fed announced that they would raise their repo rate from 0 to 0.05% annual.

They said this was a technical adjustment, which went in line with also raising the interest on excess reserves by a similar amount. Usually, a highly technical concept with a practical change doesn’t really get that much attention.

However, this one could be different.

To be fair, it’s not so much the change in the repo rate itself that is indicative of the markets. It’s the market players’ behavior, and why the Fed felt they needed to make this technical adjustment. Specifically, it’s related to inflation expectations and trying to get the stimulus money into the economy.

Basically, this change suggests that there might be a problem within the system.

What is the RRR, and why should we care?

Without getting into the technicalities, “repo” is a form of short-term loan that is done by a financial institution, typically with another financial institution (like the Fed).

They are meant to be used to deal with cash-flow issues. On a macro scale, this is what we call “liquidity”. This is why the Fed adjusts its repo rate when the market is having liquidity problems.

A “repo” is when the borrower puts up some kind of collateral (typically a treasury bond), to get a short-term loan. A “reverse repo” works in the opposite direction.

So, a bank will access the “repo” rate if they want to borrow money from the Fed (and put up collateral). Or they will access the “reverse repo” rate if they want to deposit money at the Fed (and get collateral).

The standard time for this is “overnight”. Therefore, it’s an ultra-short-term loan, basically for large institutions to put their money somewhere while settling their books.

What it means in practice

If a lot of people are withdrawing money from the financial system, then banks need liquidity. Thus, they go to the Fed through the repo rate to settle their books overnight and then sell treasuries or whatever else the next day.

If people are putting money into the financial system, then there is an excess of capital.

The Fed charges interest on banks who have “too much” capital, so many will opt to “park” it in the reverse repo facility. This pays virtually no interest. Putting money into the RRR facility, therefore, is a “last resort” for financial institutions.

Lately, there have been increasing amounts of money being “parked” in the RRR facility. This is important because these are historically the highest deposited amounts.

However, this is the opposite of what the Fed is trying to do with QE. In QE, the Fed buys bonds to put money into the financial system. In RRR, the financial system gives money to the Fed in exchange for bonds as collateral.

How does this affect policy?

There has been a spike in RRR deposits since March, reaching way above what was seen in the pandemic.

This suggests that the Fed’s QE program has reached its limit, and the money they are putting into the market from their bond purchases is just coming right back. This is mostly because banks don’t have anyone to lend it to.

The other problem is a lack of collateral. Basically, if financial institutions don’t have any bonds or treasuries, then they can’t do repo operations and are forced to deposit the money with the Fed. This means that the QE program might have reached its limit because they bought up almost all of the available bonds.

Either way, it’s a sign that the Fed might need to start tapering sooner rather than later. That is assuming they don’t want to follow Japan into a liquidity trap.

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