From One Crisis to Another (2008–2020): A Transformative Decade for the Fed

Abstract

This article sheds light on the crisis of September 2019 by placing these events in the broader context of monetary policy normalization. It starts by recalling how the operational framework of the Fed evolved since the global financial crisis. Normalization principles, the issues that arose from them and the actual normalization process are then examined. This historical sequence is interesting because it provides insights on (1) the interplay between monetary policy and liquidity regulations and (2) the advantages and limitations of different operational frameworks (corridor vs. floor systems).

Keywords:

• Federal Reserve
• monetary policy normalization
• operational frameworks
• repo crisis
• liquidity regulations

JEL Classification Codes:

• E42
• E50
• E52
• E58

Notes

1 In theory, no banks should be willing to borrow in the Fed funds market at rates above the primary credit rate: they would rather borrow at the discount window. However, the primary credit rate could be considered as a “soft ceiling” because of the so-called stigma associated with discount window borrowing: some institutions may have preferred to borrow at rates above the primary credit rate to avoid reputational risks.

2 Reserves in excess of these required reserves are called “excess reserves.”

3 The seller is often a primary dealer (Bernanke 2005).

4 In a repurchase agreement, the Fed buys a security with an agreement to resell it at a future date. The operation is tantamount to a loan collateralized by the security. Reserves are only temporarily added to the system since the transaction is reversed at maturity (the security bought by the Fed is repurchased by the seller). In the case of a reverse repo, the Fed sells a security and agrees to repurchase it at a later date, which is equivalent to collateralized borrowing.

5 While textbooks usually posited that there is a “liquidity effect”—that is, that the Fed must engage in open market operations to change the level of the FFR—the existence of this “announcement effect” has been well documented (Fullwiler 2003).

6 Foreign banks are exempt from paying FDIC fees and are often subject to a lighter version of Basel III under which the leverage ratio is calculated on a month-end or a quarter-end basis, against a daily basis for the U.S. banks. Foreign banks are therefore less constrained than U.S. banks. Keating and Macchiavelli (2017) find that most of the IOER arbitrages are undertaken by foreign banks, which gives credit to the idea that regulatory costs reduce the incentive to arbitrage.

7 For a detailed list, see Federal Reserve Bank of New York (2021).

8 As the Fed’s portfolio shrinks, the amount of reserves in the system declines. Hence the term “balance sheet normalization”: the Fed’s balance sheet decreases on both sides.

9 This first rate hike was justified by the fact that the unemployment rate was approaching its so-called natural level and that the economy was operating close to its potential. This was summarized by Chair Yellen in the following way: “if we do not begin to slightly reduce the amount of accommodation, the odds are good that the economy would end up overshooting both our employment and inflation objectives” (Federal Open Market Committee 2015b, 10). For a thorough critique of this decision, see Dantas (2016).

10 Before the crisis, the Treasury deposited most of its cash balances at private depository institutions due to the Treasury Tax and Loan (TT&L) program. But with the introduction of the IOER, it became more advantageous for the Treasury to keep its balances in the TGA. If the Treasury had placed its cash balances in TT&L accounts, the Fed’s interest expenses would have increased because of interest paid on reserves. This increase in the interest expenses of the Fed would have reduced its net income, which is transferred to the Treasury. And since the rate paid on TT&L accounts was close to zero, the Treasury would have lost more than it could earn from private depository institutions (Santoro 2012). The TT&L program was put to an end in 2012.

11 This is allowed by Title VIII of the Dodd-Frank Act of 2010. Financial Market Utilities are “multilateral systems that provide the infrastructure for transferring, clearing, and settling payments, securities, and other financial transactions” (Board of Governors of the Federal Reserve System 2015a). The Financial Stability Oversight Council (2012) designated eight systematically important FMUs. Examples of systematically important FMUs include CHIPS, CLS Bank, or the Chicago Mercantile Exchange. For more details see Board of Governors of the Federal Reserve System (2015a).

12 We will only focus on what is necessary for our analysis. See Bank for International Settlements (2018) for a brief presentation of the LCR and Bank for International Settlements (2013) for an extended one.

13 His argument relied on the supposition that the Fed would require that banks hold a certain fraction of their HQLA portfolios in reserves (Pozsar 2016, 9). Noting that the Fed had been implementing stricter rules than those of the Basel III baseline so far, Pozsar believed that the Fed would impose a minimum target of at least 35% of reserves for HQLA portfolios. In May 2018, the Vice Chairman for Supervision of the Board of Governors was asked about the existence of such a rule and about the possibility of meeting the LCR with “alternatives and not just with the reserves” (Wall Street Journal Pro 2018). He replied that he knew that “that message has been communicated, at least in some supervisory circumstances, in the past” (Wall Street Journal Pro 2018). But he added that it was “in the process of being rethought” (Wall Street Journal Pro 2018).

14 The Fed conducted two Senior Financial Officer Surveys in September 2018 and February 2019 to collect “quantitative and qualitative information from senior financial officers from each respondent bank on their reserve management practices and money market participation” (Board of Governors of the Federal Reserve System 2018, 1).

15 The Financial Stability Board, in consultation with the Basel Committee on Banking Supervision and national authorities, establishes an annual list of G-SIBs since 2011. G-SIBs are subject to stricter regulatory requirements and face stronger supervision.

16 On December 13, 2015 the EFFR traded five basis points below the Fed’s target range but this year-end effect was transitory. See Potter (2016) for an explanation.

17 As of August 2018, Federal Home Loan Banks (FHLBs) represented around 95% of overnight lending in the federal funds market (Potter 2018).

18 The lowest comfortable level of reserves corresponds to the level of reserves that a bank “would hold (at the prevailing constellation of rates) before taking active steps to maintain or increase its reserve balances” (Logan 2019).

19 This is also the case for foreign hedged buyers of Treasuries. As FX hedging costs rise above longer term rates, the trade becomes unattractive.

20 The Primary Dealers Act of 1988 requires that primary dealers buy Treasuries when there are no final buyers (Pozsar 2019b).

21 The Dodd-Frank Act requires that large banks operating in the United States prepare resolution plans (“living wills”) to describe their strategy “for rapid and orderly resolution in the event of material financial distress” (Board of Governors of the Federal Reserve System 2019a). As a part of these resolution plans, banks are required to cover their theoretical cash outflows on an intraday basis (Pozsar 2019b). The resolution liquidity adequacy and positioning (RLAP) is therefore more binding than the LCR, which requires to cover theoretical cash outflows on a daily basis. Since reserves are the only instrument that provides intraday liquidity, RLAP forces banks to hold more reserves. Banks will therefore hold HQLA above the amount required by the LCR.

22 As argued above, foreign banks are less constrained than U.S. banks, which explains why they undertake most arbitrage trades.

23 Primary dealers do not have reserve accounts at the Fed because they are not banks (Pozsar 2019b). Instead, they hold an account with a clearing bank that settles their payments. Bank of New York (BoNY) is now the sole clearing bank because J. P. Morgan decided to quit the clearing business to reduce its capital surcharges.

24 In figure 3, we used the Secured Overnight Financing Rate (SOFR) as a measure of repo rates. Among the Treasury Repo References Rates published by the New York Fed, the SOFR is the broadest. The SOFR is a volume-weighted median based on transaction data from tri-party, GCF and bilateral Treasury repos (see the New York Fed’s website for more information). While it stood at 2.20% on September 13, it rose to 2.43% on September 16 and reached 5.25% on the September 17.

25 This spike in repo rates raises the question of why lenders did not increase their lending in the repo market to take advantage of high rates. Internal liquidity stress tests and resolution planning, respectively required by Regulation YY and Dodd-Frank, may have prevented banks from lending their excess reserves. Under these regulations, banks are expected to be able to cover their theoretical outflows on an intraday basis. J. P. Morgan’s CEO argued that its bank was constrained by these regulations, which is consistent with another declaration made by Vice Chair Quarles (Tarullo 2019). However, other lenders that are not subject to these regulations were also reluctant to increase their lending. High uncertainty regarding the nature of the spike and cash flows certainly played a role (Anbil, Anderson, and Senyuz 2020).

26 The proceeds of tax payments and Treasury settlements go to the Treasury General Account at the Fed, which drains reserves from the banking system.

27 At maturity, reserves are drained when the security is repurchased by the counterparty. Hence the name temporary open market operations (TOMOs).

28 Some market observers interpreted this as a new round of quantitative easing (“QE 4”). Powell recalled that permanent open market operations (POMOs) are purely technical and that they should not be confused with large-scale asset purchase programs (Federal Open Market Committee 2019k, 3).

29 During the press conference of January, Powell recalled that this level stood around 1.5 trillion. But he added that this was the “bottom end of the range”: “reserves will fluctuate and be substantially higher than that most of the time” (Federal Open Market Committee 2020c, 6–7).

30 A broad set of measures was taken in March to alleviate strains in several financial markets. But we will only focus on what is relevant for our analysis. For a brief overview of the Fed’s response to the COVID crisis, see Federal Reserve Bank of New York (2020d).

31 A variety of investors sought to sell their securities for different reasons. The main sellers of Treasuries were mutual funds (to meet record withdrawals), foreign officials like central banks (to raise dollars for foreign exchange intervention, to satisfy local dollar funding needs . . .) and hedge funds (unwinding basis trades). For more information on the disruptions of the Treasury market, see, for example, Financial Stability Board (2020, 30–32), Vissing-Jorgensen (2020), Schrimpf, Shin, and Sushko (2020).

32 Between March 15 and April 22, the Fed bought more than $1.3 trillion of Treasuries. In comparison, the Fed bought $300 billion of Treasuries over one year for QE 1, $600 billion over eight months for QE 2 and around $800 billion over almost two years for QE 3. In addition, the Fed bought $458 billion of MBS from March 16 to April 13. For more information on the dealer/market maker of last resort, see Buiter and Sibert (2007) or Mehrling (2011).

Additional information

Notes on contributors

Rudy Bouguelli

Rudy Bouguelli is an associate professor of economics at Université Paris Cité (LADYSS), Paris, France. This research benefitted from a grant provided by the Institute for New Economic Thinking (INET) for a project dedicated to central banks, crises and income distribution. The author would like to thank Marc Lavoie, Godefroy Clair, and two anonymous reviewers for their helpful comments.