The US Federal Open Market Committee held two days of meetings this week. The headline decision was to continue asset purchases at the current pace, and keep the Fed Funds rate between zero and 25 basis points, while continuing to watch employment and prices.

Consigned to its "implementation note," outside of the main statement, was a decision to raise two other policy interest rates, the interest on excess reserves rate, from 10 to 15 basis points, and the rate paid in the overnight reverse repo facility, from 0 to 5 basis points. I've seen this read in two ways: as a technical matter of no great significance, or as a hawkish move that signals the beginning of tightening.

It is neither. Raising these two overnight rates is an unavoidable tightening intended to keep money markets functioning while the Fed continues easing through expansion of its balance sheet. Downshifting, if you like.

March 2020 to March 2021

Starting from the big picture:

In March 2020, at the beginning of the COVID-19 pandemic, the Fed quickly bought more than $1 trillion in Treasuries and mortgage-backed securities, and has continued to do so at a constant clip ever since. This has brought the total size of the central bank's balance sheet from $4 trillion at the beginning of 2020 to $8 trillion today.

These purchases were funded by an expansion of the deposits of the US banking system (reserves), from which the Fed bought securities in the secondary market, and the US Treasury (the Treasury General Account or TGA), from which the Fed bought newly issued government debt. At the same time, the Fed brought its short-term policy interest rates, the Fed Funds rate and the interest on excess reserves (IOER) rate, down to zero.

One important test is whether the repo market was able to digest all this. Repo is a way to structure secured lending and is the generic funding mechanism in the market-based credit system. The most generic transaction of all is an overnight loan of money, secured by a loan of US Treasury debt in the opposite direction. Money and collateral are returned the next day, along with an interest payment. Because the Fed is affecting the availability of both money (reserves) and collateral (Treasuries), its actions are closely connected to the repo markets. This graph says that, so far, the repo market has continued to function:

This is a summary of the repo market over the same timeframe as the Fed's balance sheet above. The graph's four panels are in two rows, with rates above and transaction (flow) volumes below; and in two columns, with a breakdown by collateral on the left and tenor (maturity) on the right.

The top two panels show that the Fed brought rates down relatively smoothly in March 2020, and they have been there since. The lines don't cross, meaning that normal spreads by collateral and tenor have more or less been maintained. Likewise the bottom two panels show that transaction volumes spiked at the beginning of the pandemic, and were largely stable until March 2021.

March 2021 to today

The graph also shows that things have changed since March 2021. The two bottom panels show that the flow of overnight repo against Treasury collateral has increased by $500 billion since that time. This incurred a couple of blips in rates, but no more than that.

Two things changed in March: the Treasury started spending down its account, while the banking system's capacity to absorb new reserves was reached, or nearly so. In the graph of the Fed's balance sheet above, reserves, the brownish segment in the lower panel, have been close to flat since then, while the Treasury's account, in green, has declined. But assets continue to expand, so liabilities must also.

That expansion has come in the form of secured borrowing at zero interest through the overnight reverse repo (ON RRP) facility, the yellowish segment just below reserves on the Fed's balance sheet. The decision to continue asset purchases, and the Treasury's plans to spend down the TGA, mean that the ON RRP facility will continue to grow for now.

This has put new strains on money markets. This graph shows interest rates for key overnight funding mechanisms.

These are all overnight rates. Interest on excess reserves is the interest that the Fed pays banks on their deposits. Fed Funds and the overnight bank refinance rate are measures of what banks pay each other for unsecured loans. The secured overnight financing rate and the tri-party general collateral rate are measures of secured repo lending. Although the rates are very low and the spreads are tiny, remember that the daily transaction volume in these markets is more than a trillion dollars. Note that for most of the pandemic, these rates have stayed more or less in order: IOER > FF > OBR > SOFR > TGCR.

But that pattern has broken down since March. The secured measures, SOFR and TGCR, are pressed together at the bottom as the ON RRP facility expands. For money markets, the collapse of spreads at zero is like trying to use a compass while standing on the south pole—every direction is north.

So the Fed agreed to pay five basis points in the ON RRP facility, while raising IOER by the same amount to give some headroom for the other rates—it is taking a few steps off the south pole so that the compass will work again. The Fed's desired outcome of this must be a return of a stable pattern of funding costs, so that it can continue buying securities without breaking money markets.

My take on the Fed meeting

So, the Fed said this week that the Fed Funds rate will start to rise two years from now, and until then asset purchases will continue until conditions improve. This is a dovish policy, massive asset purchases and zero interest for the next two years, that is being read as hawkish because the timing of the first increase in the headline rate has moved up from 2024 to 2023.

While talking about future policy, the Fed is also actually adjusting policy now. It is increasing rates at the very shortest end to make them positive again. This could (wrongly) be interpreted as a hawkish policy because it is an increase in rates.

It would be more accurate, I think, to read it as an indication that the Fed is in fact having to work quite hard to continue to provide accommodation. It can no longer create new reserves for banks, so now it is creating new reserves for money funds, and in order to do so within the existing financial system, it actually has to raise rates so that it can get some traction. That represents a very different worry—and a much more dovish one—than runaway inflation.

Previously on Soon Parted

• The post-pandemic Fed: early hints

• The 2008 Crisis, part 3

• The 2008 Crisis, part 2

• The 2008 Crisis, part 1

• Whatever it took