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A Challenge for the Fed: Some Overnight Rates Are Falling Below Zero
By Christopher M. Russo
Since the onset of the pandemic, the Federal Reserve has held short-term interest rates to near zero. By keeping financial conditions loose, officials aim to promote a faster economic recovery. But in recent days, some interest rates have drifted lower and even turned negative. Mercatus research fellow Christopher M. Russo explains what’s going on and why it’s important. He’s a former Fed economist, most recently on the New York Fed’s Open Market Trading Desk, and he’s an expert on U.S. monetary policy, sovereign debt and financial market functioning.
What does it mean for interest rates to go negative?
An interest rate is the cost of borrowing money. When interest rates are positive, borrowers pay lenders a premium. For example, you receive interest on your savings account, but you pay interest on your mortgage. Negative rates flip that around: lenders pay borrowers a premium. In recent weeks, some short-term interest rates have been pressured down to zero and have sometimes turned slightly negative. Without Fed action, these short-term rates may turn more negative over the next few weeks.
What interest rate has gone negative?
The interest rate on repurchase agreements, or “repos,” backed by U.S. Treasury debt has fallen below zero. Banks and other financial institutions commonly use repos to finance themselves: They sell an asset under an agreement that they will buy it back tomorrow at a fixed repurchase price. When the repurchase price is higher than the original sale price, interest rates are positive: It costs money to borrow overnight. When the asset used as collateral is high quality, such as U.S. Treasury debt, the loan is almost risk free. If a bank or other borrower defaults, meaning it doesn’t buy the asset back as agreed, then the lender gets to keep the asset.
But haven’t longer-term rates been rising?
Near the start of the pandemic, interest rates on longer-term Treasury debt fell sharply to their lowest levels ever. In part, this fall represented a “flight to quality” often seen during times of crisis, as well as lowered expectations about economic growth and inflation. But as the economy recovers, longer-term interest rates have been rising. The rate on a 10-year Treasury is now around 1.6%, roughly its original level.
However, rates on short-term Treasury debt, maturing in one year or less, are still near zero. An overnight loan backed by Treasury debt has about the same risk: almost none. As a result, short-term Treasuries and Treasury-backed repos have closely related interest rates. Rates on longer-term Treasuries carry more risk, and so investors require a higher interest rate.
Why does the Fed care about negative interest rates anyway? If it’s right that lower interest rates help boost the recovery, wouldn’t negative interest rates work even better?
Some economists have argued for a policy of negative interest rates. Other central banks, notably the European Central Bank and the Bank of Japan, do have negative interest rates. But in the past, Fed officials have argued that negative interest rates in the U.S. would provide only a small boost at best, while weakening the banking system by hurting bank profits. If negative interest rates make banks less likely to lend, then negative rates could even slow economic growth. As Chairman Jerome Powell said in 2020, “There’s no clear finding that it actually does support economic activity on net, and it introduces distortions into the financial system, which I think offset that.”
Right or wrong, the Fed has a short-term interest rate target of between 0% and 0.25%, or one-quarter of a percentage point. I anticipate that it will continue to use its tools to achieve that target.
What tools can the Fed use to keep short-term interest rates out of negative territory?
One of the Fed’s tools is the Overnight Reverse Repurchase Agreement facility. Each day, the Fed offers to borrow overnight at a rate equal to the bottom of the target range for short-term interest rates. This rate is now zero. The loan is structured as a repurchase agreement, with the Fed temporarily selling a Treasury security from its portfolio. In principle, this practice means that Treasury repo rates should stay out of negative territory. Why lend at a negative interest rate, and lose money, when you can lend at zero to the Fed?
Among other options, the Fed could also make a “technical adjustment” by increasing the interest rate it pays, either on these loans or on bank deposits it holds. The latter is known as the “interest on reserves” rate. In the past, the Fed has used technical adjustments to the interest-on-reserves rate to keep short-term interest rates trading toward the middle of their target range.
Has the Overnight Reverse Repurchase Agreement facility been effective at keeping rates out of negative territory?
So far, interest rates have generally stayed out of negative territory but have dipped into it at times. Thursday’s Secured Overnight Financing Rate, a broad measure of repo rates published by the New York Fed, stood at 0.01%. However, across all of the repo transactions used to calculate that rate, some were negative. The first percentile of these transactions carried a rate of negative 0.03%. The fed funds rate, another measure of overnight lending, has remained firmer. Thursday’s effective fed funds rate printed at 0.07%.
Take-up for Thursday’s Overnight Reverse Repurchase operation was almost $27 billion, with 25 counterparties. While this amount was much higher than the take-up recently, the Fed was prepared to borrow even more. On Wednesday, the Fed increased the per-counterparty limit (the maximum amount that any one lender could take) from $30 billion to $80 billion. It’s puzzling that some repo transactions occurred at negative rates despite additional capacity at the Fed.
Interest rates might turn more negative over the next few weeks. Why?
Under the current path of monetary policy, reserves are likely to increase substantially over the next several weeks. First, the Fed is continuing its pace of asset purchases: $80 billion a month of Treasury securities and $40 billion a month of mortgage-backed securities. Second, the Treasury will be making large outlays from the recent $1.9 trillion spending bill. Much of this money is already on the way out the door, such as direct payments to Americans. Earlier this year, Treasury also announced its intention to substantially reduce its cash balances at the Fed to closer to pre-pandemic levels. Holding everything else equal, these actions will increase the level of reserves and further soften rates. Essentially, there is too much money sloshing around looking for safe short-term investments.
What about the Supplementary Leverage Ratio?
The Supplementary Leverage Ratio is a U.S. banking regulation adopted after the 2008–2009 global financial crisis. It’s a backstop of sorts, intended to make sure that banks always have a minimum level of capital, and it uses a calculation that banks can’t game. But in doing so, the calculation in effect treats reserves and Treasuries as risky investments. At the limit, holding more reserves and Treasuries would prevent banks from lending. And the supply of reserves and Treasuries has been dramatically expanding.
At the start of the pandemic, the Treasury market and the broader financial plumbing began to break down: Treasury securities became less liquid and interest rates started to rise. Why this happened is still not well understood. The Fed responded with a package of policy actions, including temporarily exempting reserves and Treasuries from the ratio’s calculation and increasing its pace of asset purchases. Whatever the cause, these actions seem to have temporarily fixed the problem.
How does the Supplementary Leverage Ratio relate to negative interest rates?
Some have argued that if the exemption is not extended, banks will be reluctant (or refuse) to take additional deposits. These deposits would be routed into other parts of the financial system, such as money market funds, that invest in repos. This rerouting would amount to additional dollars chasing opportunities to be lent out through repos, putting further downward pressure on short-term rates. However, others have noted that the ratio is not binding on banks now, and argue that the issue is being used opportunistically by banks to lower their capital requirements.
Today the Fed announced that the exemption will expire at the end of the month but that the Fed will seek comments on measures to adjust the ratio’s design without eroding the strength of capital requirements.