Reverse Repurchase Program and Its Use in American "Abenomics"

We all have been aware of the FED's latest decision to taper its bond-buying program by $10 billion from the Federal Open Market Committee (FOMC) meeting this week. Another interesting decision that came out, at least to me, was the decision to extend its reverse repurchase program (also known as reverse repo) by a year. By implementing reverse repurchase program, the FED aims to be able to control the short-term interest rate when it needs to raise it in the future. The advantage of this program is that the FED doesn't have to pull money out of the economy to raise the interest rate when it wants. This advantage of not having to lower the money supply in the future explains how this program can be implemented to achieve a shift in the FED's monetary policy. This shift is to follow permanent increase in the monetary base, which is what the Bank of Japan has been doing under Abenomics.

In the US, QE1 and QE2 and Japan's first QE during 2001-2006 were seen by the public as a temporary increase in the money supply by the central banks rather than permanent one. On the other hand, QE policy the BOJ has been employing since April 2013 is to double the money supply permanently. David Beckworth explained how the way public sees an easy monetary policy as temporary vs permanent money supply increase affects the performance of these QE programs. In his words:

"I have long argued, along with other Market Monetarists, that the Fed could solve this problem by adopting a NGDP leveltarget. Why would this help? The key reason is that it would create an expectation that some portion of the monetary base growth from the asset purchases would be permanent (and non-sterilized by IOER). That, in turn, would mean a permanently higher price level and nominal income in the future. Such knowledge would cause current investors to rebalance their portfolios away from highly liquid, low-yielding assets towards less liquid, higher yielding assets. The portfolio rebalancing, in turn, would raise asset prices, lower risk premiums, increase financial intermediation, spur more investment spending, and ultimately catalyze a robust recovery in aggregate demand."

In short, when people sees expansionary monetary policy as permanent one rather temporary, they will increase their spending today. For QE3, Beckworth explains that it has had some indication of permanent money supply growth with "its data-dependent nature and appears to have offset much of the 2013 fiscal drag" and this could be a reason

Now let's get back to the reverse repo program. By using this tool instead of targeting federal funds rate, it can convince the public that it will not lower the money base in the future to raise the interest rate. In other words, the FED will be able to make shift to a monetary policy that will sustain the higher monetary base created by QE3 permanently AND convince the public that it will be indeed permanent. This type of monetary policy or QE that raises the monetary base permanently rather than temporarily could achieve more private spending and economic growth as we can see from Japan's latest growth under Abenomics (one could argue that the other two main policies or arrows of the Abenomics also helped Japanese economy to improve). Of course, we cannot take the latest Japan's inflationary success and economic growth in 2013 as a product of the Abenomics. And the U.S. is far from implementing this kind of economic reform consisting of fiscal, monetary, and regulatory policies, but if the Abenomics turns out to be Japan's success story in the future, the U.S. should study this "real life experiment" of Japan. If it chooses to do the experiment on itself, the reverse repo program is their experiment tool.

The Fed's New Tool for Increasing the Short Term Interest Rate

As the U.S. economy starts to look better, the Fed eventually has to increase its federal funds rate. The Fed has stated that it is planning to keep the near zero federal funds rate until the unemployment reaches 6.5 % as long as the inflation rate and expected inflation remains low.

Now, the question is whether the Fed will be able to increase the short term rate in the economy as it desires when the correct time comes through changing its federal funds target rate. As the Fed has been conducting QEs since the recession ended, its balance sheet  reached  $4 trillion mark in last December and bank reserves at the Fed increased greatly.

Source: http://www.piie.com/publications/pb/pb14-4.pdf

To increase the short term interest rate in the future, under current system, the Fed has to sell government bonds to pull money out of the economy, therefore increases the interest rate. But since it has put in enormous amount of reserves for last few years, the Fed faces a problem of selling huge amount of asset to effectively increase the interest rate.

Since September 2013, the Fed has been experimenting a new tool to control the short term interest rate. This new tool called a reverse repurchase program works this way: the Fed sells its asset in the System Open Market Account to money-market mutual funds, banks, securities dealers, government-sponsored enterprises and others with a condition that it will buy back those assets in the future for higher price than it sold to them. In other words, the Fed, under this program, borrows from those institutions with collateral of Treasury Securities. The difference between the sale price and repurchase price along with a length of time between these indicate the interest rate the Fed pays.

When the Fed wants to increase short term rates, it can increase the reverse repurchase interest rate. When the financial institutions see this higher interest rate paid buy the Fed, they aren't willing to borrow reserves each other below this rate because they can make more buy purchasing assets from the Fed and selling back. Therefore, it can effectively put a floor for the short term interest rates that banks charge each other. Moreover, through raising this rate, the Fed can affect the overall short term interest rate in the economy. Also, using reverse repurchase program, the Fed doesn't have to shrink its balance sheet; therefore, it can use its assets when it faces a problem.

One counterproductive effect this program could have is that when the Fed shifts to this policy, the Fed will be expanding the monetary base through its payment to financial institutions. That is reverse of what the Fed tries to do when it needs to raise the interest rate in the economy.

Along with targeting reverse repurchase interest rate, the Fed has to increase the interest on reserves, which is currently 0.25%, when it raises the short term interest rate to prevent depository banks from lending too much credit and causing inflation.

This policy has been examined by the Fed since September, and there has been a research paper on its effectiveness. Whether the Fed will employ this policy in the future is interesting thing to put eye on.

Related article on the Wall Street Journal:

Former Fed Economist Call For Central Bank to Scrap Fed Funds Rate Target

Fed Moves Toward New Tool for Setting Rates