In recent years, and especially since the financial crisis of 2008, the Federal Reserve has become increasingly “transparent.” Even its financial market operations, once held as confidential, are acknowledged and, occasionally, announced.
Just recently, for example, the Fed was very active in the repo market to bring interest rates back down, and Chairman Jerome Powell discussed publicly what it had done and said it might do more of the same.
The repo market is not, as we could logically think, a market for repossessed cars, although such a market does exist. When economists, bankers, and money managers refer to the repo market, they mean the market for repurchase agreements.
In the repo market a bank, for example, can make use of its holdings of U.S. Treasury securities by selling them to a buyer and promising to buy them back. Most commonly, the buyback period is quite short — the next business day, referred to as “overnight repo,” for example — but it allows the bank to earn some interest on its portfolio.
The buyer’s side of a repo transaction is called a “reverse repo.” Those doing reverse repo transactions are typically organizations with large cash balances — banks, pension funds, insurance companies and investment funds, for example, looking for a safe place to park the cash temporarily and still earn interest on it.
The repo market is, in effect, a liquidity market where those who need cash can find those with excess cash.
Calling it a liquidity market has the advantage of explaining why the Fed was active in that market this past week. Apparently, the demand for cash had suddenly risen and, naturally, that drove up the market interest rate. In the repo market, the effective interest rate is determined by the difference between the selling price of the securities and the price to buy them back. It resembles a very short-term loan in that respect, with the difference between the sell and buy prices being the interest earned.
We might think that the interest rate is a trivial matter. After all, how much interest could a loan earn overnight? But when billions of dollars are involved, it’s substantial. At 2%, the Fed’s lower target rate, the interest on a billion-dollar overnight repo is about $55,000.
The repo market is driven by supply and demand just like any other market. To bring interest rates back down, then, the Federal Reserve jumped in and began “injecting liquidity” into the market through “reverse repo” – buying securities with an agreement to sell them back. This increased the supply of cash available to those who needed it and brought interest rates back down to within the Fed’s target range, 2 to 2.5%, at least temporarily.
To add some psychology to the market and calm down the doomsayers, the Federal Reserve said that it was prepared to supply liquidity to stabilize rates not at a fixed amount but “whatever it takes.”
The psychological element is, as always, difficult to assess or predict. After the repo market’s turmoil and Fed intervention last week, there was an abundant supply of analysts to jump up and warn that the financial apocalypse was upon us.
Lower temperature analysis of the repo market, though, suggests that the causes of the increased demand for cash — the force driving up the interest rate — lacked apocalyptic dimensions and were due to the commercial banks’ need to meet the cash needs of its corporate clients for quarter-end cash management and federal taxes. Evidence of this showed up in the banks’ strong demand for two-week repo agreements to carry them over the quarter-end cash demands.
Two important questions remain in the repo market situation. The first is whether the Fed’s action was effective; and the second is whether the Fed’s talking about it was successful in calming down the market’s volatility.
Regarding the first question, it was effective in bringing the interest rate back down to within the Fed’s target range. Whether it stays within that range depends largely on the answer to the second question.
The Federal Reserve’s increasing openness about its goals and market operations is based on its understanding of market psychology, distilled into one tenet: Volatility and speculation are fueled by the lack of solid, truthful, reliable information.
The Fed’s actions based on that tenet have thus far had mixed results. Some declarations of policy, for example, have only led to demands for more details and more speculation as to what they are.
In this case, though, the Federal Reserve pitched a perfect game. Of course, there is always another market day, and there seems to be an endless supply of people who believe we can talk ourselves into a recession and want to prove it.