FT Alphaville has discussed why western central banks might be in the midst of an existential crisis. The point rests on the fact that traditional policy transmission mechanisms appear to be dying.
Simply speaking, while most western central banks still target unsecured money market rates, the market itself has moved on. Unsecured short-term money market rates are no longer a representation of real financing costs. Trying to influence them thus makes little sense. It can achieve very little.
Given the above we were interested to encounter a number of rumours last month, which related to central banks changing their attitudes with respect to the market rates they target.
The chatter had it that targeting short-term repo rates might make much more sense, and that central banks were currently discussing the merits of a shift.
Which makes this recent powerpoint presentation by Gabriel Perez Quiros of the Bank of Spain extremely interesting. It’s a retort to a ‘very preliminary‘ paper by Elizabeth Klee and Viktors Stebunovs, from the Federal Reserve Board, which was published in September 2011 (and is also hosted on the ECB website).
The Klee and Stebunovs paper focuses on the current Federal Reserve convention to target the Fed funds rate, and why shifting to the Treasury general collateral repo rate might make more sense from a policy perspective. Here was their abstract:
Traditionally the Federal Reserve had targeted the federal funds rate, expecting this rate to transmit a monetary policy stance to other short-term and longer-term rates. However, at the height of the financial crisis, the pass-through from the federal funds rate to other short-term rates appears to have deteriorated.
Further, market participants reportedly anticipate that the inception of liquidity requirements will discourage short-term financing and might undermine the federal funds market and its linkages with other money markets. In turn, we argue that the high quality collateral repo markets should remain active. We document the presence of small liquidity effects in the repo market at both high and low frequencies; we also point at a possibility of a notable liquidity effect at low frequency present in M3 data.
We argue that, in principle, instead of the federal funds rate, the Federal Reserve can target the Treasury general collateral repo rate. The target repo rate might be a more effective policy tool than the target federal funds rate because of a broader set of repo market participants.
All of which would count as pretty radical thinking (for the Fed) if it were to catch on.
Above all, it implies that central bank economists really do feel that the current transmission may have become ineffective and that the best course of action could be for the Fed to change its thinking and deploy its System Open Market Account holdings for the purpose of influencing repo rates outright.
With regard to the SOMA holdings, the authors note:
Although, the demand schedule for repos appears to be rather flat, the size of the System Open Market Account portfolio of Treasury Securities relative to the repo market size is substantial, indicating that, in principle, the Federal Reserve can put significant upward pressure on the repo rate through large-scale reverse repos. (Large-scale repos do not require the Federal Reserve pledging any collateral.)
Their conclusion being:
The target repo rate might prove to be a more effective policy tool than the target federal funds rate in the future because of a broader set of repo market participants. The Treasury repo market is a secured, multi-trillion dollar money market with a wide set of participants–depository institutions, primary dealers, investment banks, central banks, insurance companies, industrial companies, municipalities, pension funds, hedge funds, and mutual funds, to name a few.
Hence, by targeting the repo rate, the Federal Reserve can affect the cost of funding (or the rate of return) for various institution types, strengthening the cost channel of monetary policy transmission. Moreover, the Federal Reserve can also be a liquidity source to a broad set of financial institutions.
This chart from the Perez Quiros presentation, meanwhile, is pretty good at explaining why the spread between the 3-month collateralized and uncollateralised rate is worth influencing:
Much like the Ted spread (the difference between the unsecured rate and the equivalent T-bill rate), the repo spread gets rid of the interest rate policy noise in the picture, making it a much purer snapshot of market stress. Unlike the Ted spread, however, the repo component can also act as forward indicator of rate policy:
It’s almost like the market uses the repo rate to indicate where policy should be to avoid market stress. Thus, one could say that it’s by influencing the repo rate that a central bank can really influence the market’s funding costs (at least in current conditions).
Interestingly, whether it’s been down to official policy or not, the Fed has been very effective at stabilising the collateralised/uncollateralised repo rate spread since 2008. Something which can’t be said for the ECB, however.
Furthermore, it wouldn’t be easy for the ECB to bring in repo targeting even if it wanted to.
There’s the question, after all, of which general collateral market it would need to target. Not an easy decision given the huge divergence between core general collateral rates and peripheral ones, and no common market alternative.
This is perhaps why the Bank of Spain’s Gabriel Perez Quiros isn’t entirely convinced by the Klee and Stebunovs thesis.
His presentation concludes that while the idea of targeting the repo rate might be a nice idea, the statistical evidence doesn’t really support the notion that it might be any more effective.
Nevertheless, what is clear is that the repo targeting discussion is being had, and on a relatively influential level.
A target Treasury general collateral repo rate: Is a target repo rate a viable alternative to the target federal funds rate? – FRB
For the love of Ronia (and repo) – FT Alphaville
The cost of global central bank balance sheet expansion – FT Alphaville
On the perils of plunging repo rates – FT Alphaville