QE vs The SRF: Shackled By A Poor Diagnosis
It is entirely possible that the Fed does recognize the limitations of its domestic standing repo facility (SRF), but cannot do much about it.
After all, the Fed doesn’t issue USTs – that’s the Treasury’s job, which means that the Treasury is best placed to increase the amount of collateral in the financial system, by issuing more debt, specifically T Bills.
Unfortunately, the Treasury can’t simply go ahead and sell more T Bills, because it issues debt based on budgets that are decided by Congress.
This makes the amount of debt issued by the Treasury a political issue, fought over by fiscal hawks and doves, and in some electoral cycles even serves as the basis of politicians’ campaigns.
Collateral scarcity really isn’t something that most politicians are concerned about , much less understand.
More importantly, having a country issue more debt just to prevent collateral shortages is not a desirable or sustainable solution. After all, the country has to pay interest on that debt, as well as repay the amount borrowed at some point in the future.
Moreover, issuing more debt comes with other systemic consequences, such as capital flowing to purchase the newly issued debt instead of investing in the real economy. This can lead to second order effects such as lower economic growth and a fall in government tax revenues.
Consequently, the best course of action left to the Fed is to not reduce the amount of collateral in the system.
In other words, halting their purchases of USTs via QE. However, this also isn’t a perfect solution, as the Fed learned in 2020 to not purchase T Bills (the best kind collateral), concentrating its purchases at the long end of the curve instead.
This means that QE no longer removes the repo market’s preferred form of collateral, and consequently should not negatively affect the repo market as much.
Unfortunately, as record use of the Fed’s Overnight Reverse Repo Facility shows, demand for collateral is sky high – to the extent that market participants want to borrow more than a trillion (at time of writing) of the Fed’s USTs for use as collateral.
Since the Fed mainly purchases longer tenor USTs now, this means that repo market participants are increasingly using long end USTs as collateral, at least for the moment.
Why is this the case?
Because of second order effects. As the Treasury reduced issuance of T Bills from the large amounts they were borrowing around the middle of last year (when the pandemic first hit), the repo market has had less to use as collateral.
Consequently, repo participants have had to move up the yield curve and use longer dated USTs to meet their collateral needs – to the point where the Fed’s RRP is seeing record high levels of use.
This means that the Fed, if it wants to stop exacerbating the collateral shortage, needs to stop QE.
However, the only way they would do that is if it somehow shifts away from their bank-reserves-are-money paradigm, which unfortunately for the rest of us, probably isn’t going to happen anytime soon.
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