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By Adam Copeland and Owen Engbretson
The Federal Reserve’s 2022-23 tightening cycle involved the use of two monetary policy tools: changes in administrative rates and changes in the size of its balance sheet. This post highlights the results of a recent Staff Report that explores how these tools affect money market conditions. Using confidential trade-level data, we find that both tools have significant effects on the pricing of funds sourced through repo. These results suggest that the Fed can manage how financing conditions are affected even as it influences economic conditions. For example, the Fed can lower its administrative rates to loosen economic conditions, while shrinking its balance sheet to maintain financing conditions in the money markets.
Background
Our analysis focuses on Treasury repurchase agreements (repo), a critical financial market used to secure funding and provide liquidity, with an estimated size of over $5 trillion outstanding in the first half of 2024 (see the appendix of this white paper). Secured funding trades in the US are often documented as repos, and within repo, trades involving Treasury securities are the dominant type. Using data on Treasury repo, then, provides a representative look at secured funding conditions in the US.
The US Treasury’s Office of Financial Research’s (OFR) centrally cleared repo collection provides such data. This collection captures most interdealer trading. Furthermore, a portion of dealer-to-client repo transactions are gathered through the central counterparty’s Sponsored Service program, providing a window on pricing of trades between dealers and their mutual fund and hedge fund clients (see this Staff Report for more details on Sponsored Service).
Dealers are the main intermediaries in secured funding markets, borrowing from cash-rich investors such as money market mutual funds and lending to levered clients such as hedge funds (see this comprehensive report on dealers’ intermediary activities). The OFR data allow for the construction of the spreads charged by dealers to intermediate funds, as we observe the repo rate dealers’ charge to lend funds to levered clients as well as the rates paid to borrow funds from mutual funds. The chart below shows the distribution of those spreads for overnight Treasury repo for each quarter from 2020 to 2024.
These statistics suggest that dealers charged wider spreads to intermediate funding with the tightening of monetary policy, which began in March 2022. The chart below displays the changes to monetary policy, both in terms of changes to the Fed’s administrative rate of interest on reserve balances (IORB) and to the Fed’s balance sheet (our measure is the amount of reserves that banks hold at Federal Reserve Banks plus the amount of cash placed at the Federal Reserve overnight reverse repo facility, hereafter, Fed liabilities). Over the sample period, IORB increased from 15 to 540 basis points, with large steps up in 2022. At the end of the sample, in the last half of 2024, there are three decreases in IORB. Fed liabilities are hump-shaped: Starting at about $4 trillion, they rise steeply in 2021 to almost $6 trillion. They then stay roughly flat through the beginning of 2023, before steadily falling through 2024, reaching $3.5 trillion by December 2024.
Analysis
Our analysis focuses on how monetary policy affects the cost to dealers to intermediate funding among clients. As intermediaries, dealers face risks, even for short-term trades where funding is secured by high-quality collateral (see this Treasury Market Practices Group white paper for a distillation of these risks). To mitigate these risks, dealers often hold a buffer of liquid securities, where the cost of holding this buffer should be reflected in the spread charged by the dealer.
We term this cost the liquidity risk premium and note that this premium should vary with the opportunity cost of holding cash. Changes in monetary policy, both in terms of IORB and Fed liabilities, change the opportunity cost of holding cash. Our main empirical exercise, then, is to estimate how changes in both IORB and Fed liabilities influence the spreads charged by dealers to intermediate funds. The identifying assumption of this analysis is that the decision to change rates or Fed liabilities is exogenous to the spreads charged by dealers, a plausible assumption for this period of analysis when the Fed wanted to move from abundant to ample reserves.
Our main results are that both an increase in IORB or a decrease in Fed liabilities raises the liquidity risk premium, driving up the cost of intermediating funding. The estimates imply that a one standard deviation increase in IORB, or 226 basis points, drives up the liquidity risk premium by 2.1 to 3.5 basis points. A one standard deviation increase in Fed liabilities ($750 billion) drives down the premium by 1.6 to 2.5 basis points. These are economically significant effects, as evidenced by the fact that the average spread dealers charge clients to intermediate funding in the sample period is 7.5 basis points.
The cumulative impact of each monetary policy tool on the liquidity risk premium is illustrated in the chart below. The estimated cumulative effects naturally mirror their respective monetary policy tools, although the magnitudes slightly differ because of the estimated nonlinear effects. For example, a $1 billion change in Fed liabilities has a larger estimated effect on the liquidity risk premium when IORB is low compared to when IORB is high.
Takeaway
Over the last monetary tightening period, the Fed’s increase in IORB and decrease in Fed liabilities both drove up the opportunity cost of money, pushing up the liquidity risk premium. A key insight from the results is the possibility of a wider range of outcomes on how the Fed impacts the money markets. For example, in a hypothetical situation where the economy needs support and the level of financial sector leverage is concerning, the Fed has tools available to offset both issues: lowering interest rates and decreasing its liabilities.
Lowering rates would bolster the economy through the usual channels, and a large enough decrease in Fed liabilities would result in a widening of the spread dealers charge clients to intermediate funds, dampening overall financial sector leverage. We can quantify those effects on the liquidity risk premium. Using the values of rates and Fed liabilities at the end of the sample period, our results imply that a 100-basis-point decrease in IORB and a $400 billion decrease in Fed liabilities would have largely offsetting effects on the liquidity risk premium.
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