NY Fed blog explores two sides of monetary policy

The US Federal Reserve’s short-term rates and balance sheet size both have significant effects on money market conditions through the price of Treasury repurchase (repo) agreements, researchers have found.

In a blog post on April 6, the New York Fed’s Adam Copeland and Owen Engbretson used confidential trade-level data from 2020 to 2024 to explore how changes in the Fed’s administered rates and balance sheet size influenced Treasury repo market conditions.

The researchers evaluate market conditions by calculating the spreads charged by dealers to intermediate – the rates they charge to lend to leveraged clients, such as hedge funds, versus the rates they pay to borrow from cash-rich players, such as mutual funds.

The authors explain that dealers calculate the spreads by evaluating the liquidity risks they take on to intermediate funding among market participants. This “liquidity risk premium” should vary with the opportunity cost of holding central bank reserves, they add.

“Our main results are that both an increase in IORB [interest on reserve balances] or a decrease in Fed liabilities raises the liquidity risk premium, driving up the cost of intermediating funding,” Copeland and Engbretson write.

They find that a one standard deviation increase in IORB – or 226 basis points – drives up the liquidity risk premium by 2.1–3.5bp, while a one standard deviation increase in Fed liabilities – $750 billion – lowers the premium by 1.6–2.5bp. 

The effect is non-linear. For example, a $1 billion change in Fed liabilities has a larger estimated effect on the premium when IORB is low than it does when IORB is high.

“A key insight from the results is the possibility of a wider range of outcomes on how the Fed impacts the money markets,” the authors conclude. “For example, in a hypothetical situation where the economy needs support and the level of financial sector leverage is concerning, the Fed has tools available to offset both issues: lowering interest rates and decreasing its liabilities.”