The topsy-turvy world of the Fed's exit strategy: all too familiar to emerging countries

Jon Hilsenrath, of Wall Street Journal, reflects on the details of the Fed's exit:

• The Fed’s primary tool is an interest rate it pays banks for the money they have on deposit with the central bank, known as interest on excess reserves, or IOER. This will be the upper end of the band. This rate is now 0.25% and seems likely to go to 0.5% with the Fed’s first rate increase. The lower end of the band will be interest the Fed pays money market funds and other nonbanks for cash not on deposit at banks (known as the overnight reverse-repo rate, or ON RRP in Fed lingo). This is now 0.05% and seems likely to go to 0.25% with the Fed’s first rate increase. “Most participants anticipated that, at least initially, the IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range,” the minutes said.

The big winners, he argues, are foreign banks, who earn nice returns from this band: borrowing from money market funds at or around ON RRP, and then placing it with the Fed at the IOER rate. Domestic banks cannot play this game because fees to the Deposit Insurance Corporation eat in the spread.

Two observations:

1. The band -  - the corridor set by the IOER rate and the ON RRP - under QE is functionally different from the band set by the standing facilities under 'normal' interest rate policy. In the latter case, the upper limit is set by the rate at which the central bank lends to commercial banks. Currently, both the upper and the lower ends are rates at which the central bank mops liquidity from the system. Hence foreign banks' behavior. 

All sorts of interesting questions arise if  foreign banks borrow from money market funds through repos (as they probably do): against what collateral, on what haircuts, what does it mean for collateral velocity, re-hypothecation and other systemic repo practices. Or how relevant is the distinction that the Fed makes between banks and money market funds (shadow banks).

2. Emerging countries know this predicament too well. Or, to be precise, their central banks. In  emerging countries with open capital accounts and large capital inflows, central banks create most of their base money (bank reserves) through interventions in foreign currency (fx) markets. 

What is the exact mechanism? Central banks buy foreign currency to prevent excessive appreciation of the domestic currency (concerned by competitiveness, or domestic credit/asset bubbles).  Central banks pay for FX purchases with new base money, and then worry about the impact on monetary policy. When not at the zero bound, new base money (new reserves), will push the interbank money market rate below the policy rate, de facto relaxing monetary conditions. 

The band thus becomes an important policy tool (see this paper on the central bank of Turkey very complex mechanism). Central banks can mop up liquidity passively, accepting excess reserves at the deposit facility (a la IOER) or actively, through sterilization operations (issuing own debt, taking deposits, see here for a BIS paper on Asia etc). For instance, the outstanding stock of central bank debt for China stood at 18% of GDP in 2007.

Just like the Fed, the emerging country central bank pays interest on the  excess reserves deposited at the standing facility since active sterilizations can be too costly (typically at the policy rate).  Therein lies the trade-off. 

If it wants to avoid excessive volatility of targeted market rate, the central bank has to set a narrow band. But where the policy rate is high, a narrow band offers commercial banks a nice return on risk-free placements. This can become a self-defeating strategy since this the liquidity operations of the central bank become a perfect carry vehicle, particularly for foreign banks. Foreign banks can borrow from the parent abroad, sell the foreign currency to the central bank in the fx market, and place the reserves thus obtained back at  the central bank. Central bank interventions perversely attract further capital inflows, as the IMF recognized when it sanctioned capital controls in 2010.

To contain this carry, the central bank may choose to broaden the band, accepting higher volatility of market rates (yet inconsistent with inflation targeting regimes). Take the example of Romania. Since 2009, the EU country with the highest policy rate (fighting Hungary for the position), its central bank maintained an 8% band between the lending and the IOER rates until March 2012, and reduced it to 6% afterwards. To put this in perspective, the Fed targets a 0.2% band.

Standing facility corridor, policy rate and overnight money market rate, Romania

Capital outflows and uncertainty tightened market liquidity before 2010, and again at the height of the European banking crisis in the summer of 2012. Since then, abundant liquidity has pushed market rates to the floor set by the Romanian IOER. De facto, money market rates in Romania are closer to the ECB policy rate than the local central bank's.  For the Romanian central bank, the reserve mechanism is a capital account management instrument, not an inflation targeting instrument. If it wants to attract capital inflows, or to contain outflows, the central bank raises the IOER, or issues new sterilization instruments.

The lesson for the Fed is that raising rates in a world of excess reserves  depends on the corridor that it puts around market rates. Just like in emerging countries, the lower bound - the rate on reverse repos in this case - matters more. Put differently, although the Fed has backtracked from replacing the Fed Funds rate with a repo rate, in practice the reverse repo facility is the new kid in town. Is this the Fed preparing for the world of shadow banking - the repo dealer of first and last resort?