What happened?

In the early morning of June 17, Beijing time, the Federal Reserve issued an interest rate resolution, which still decided to keep the policy rate near zero and the size of QE bond purchases unchanged, but raised two major management interest rates.

Specifically, the Fed raised the upper end of the federal funds rate range, the excess reserve rate (IOER), from 0.10% to 0.15%, and the lower end of the federal funds rate range, the overnight reverse repo rate (ON RRP), from zero to 0.05%. The two major interest rate adjustments will take effect on June 17, local time.

In addition, the Fed significantly raised its inflation expectations for this year, reiterating that the rise in inflation was mainly due to temporary factors, but sent a signal that interest rates were more likely to rise two years later, that is, in 2023. Fed policy makers expect a rate hike to come sooner than when the expected interest rate route was announced in March.

What are IOER and ON RRP?

The full name of IOER is Interest Rate on Excess Reserves, that is, the interest rate on excess reserves. The so-called excess reserve refers to the part where the actual reserve of commercial banks and deposit financial institutions in the deposit account of the central bank exceeds the legal reserve. The Fed pays interest on excess reserves, and its interest rate is the interest rate on excess reserves.

IOER is the upper limit of Fed interest rates. An IOER greater than zero means that commercial banks' daily excess liquidity can be placed at the Fed for a free lunch, so unless the federal funds rate is higher than IOER, commercial banks have no incentive to transfer their excess reserves for lending.

The overnight reverse repo facility (ON RRP) is a tool for the Fed to withdraw liquidity from non-bank institutions, especially money market funds, in order to quickly absorb excess liquidity from outside the banking system in the short term. Money market funds, federal housing loan banks and other institutions deposit excess reserves in Fed accounts and earn interest through repo transactions.

ON RRP is the floor of the Fed's interest rate, and if the federal funds rate is lower than the reverse repo rate, then non-banks will choose to lend money to the Fed, eventually straining the market and raising the federal funds rate.

The federal funds rate fluctuates between this upper and lower limit.

What does it mean?

Haitong macroscopical Liang Zhonghua and Li Jun analyzed and pointed outThis adjustment is not a rise in interest rates, but a technical adjustment to the framework of the interest rate corridor:

On the one hand, it is to solve the problem of the falling effective federal funds rate.For example, it fell to an all-time low of 0.05% on April 30, and has fallen to 0.05% many times since then.On the other hand, it is to solve the problem that the amount of overnight reverse repurchase is increasing and the money market interest rate is above 0%.For example, since June 9, the amount of overnight reverse repurchase has exceeded $500 billion every day.

This round of reverse repurchase by the Fed was launched in March this year and remained within 100 billion yuan until late April. But as of June 16, the Fed's reverse repurchase exceeded $500 billion for five consecutive trading days, the highest since the data began.

The surge in reverse repo balance reflects the current situation of excess liquidity of US dollars in US financial markets.In other words, overnight reverse repurchase is a haven for market funds during periods of excess liquidity.

When there is excess liquidity, market funds tend to buy US Treasuries in pursuit of safe assets. when a large amount of money buys US Treasuries, US Treasury yields will continue to decline and may even fall into a negative interest rate range. At this point, the overnight reverse repo agreement has become a safe haven for market funds, because the overnight reverse repo rate acts as the lower limit of the Fed's interest rate corridor, and because the Fed does not want to fall into negative interest rates, so even in the post-epidemic environment of zero interest rates, the overnight reverse repo rate is also at 0%.

Before the increase, ON RRP interest rates were only zero, still attracting a lot of money. This means that money chasing short-term yields has nowhere to go and can only be put into the Fed without interest.

Wall Street analysts have previously pointed out that a moderate increase in ON RRP interest rates can not only withdraw excess excess liquidity, but also correct the response of interest rates to money markets and allow deposit institutions to maintain normal operations (positive small profits).

ING, the Dutch international group, believes that although the increase in IOER and ON RRP is a technical move that the Fed has downplayed, the impact and marginal direction of the policy are still clear:

This is certainly not a policy relaxation and actually coincides with a series of recent similar tightening measures, including the Fed's decision in March not to renew SLR relief measures and the announcement earlier this month to sell off corporate bond instruments that were specifically bailed out during last year's epidemic.

ING pointed out that the increase in ON RRP interest rates alone will not reduce the use of reverse repos by financial institutions, but combined with the rise in IOER, it may push up the market-driven guaranteed overnight financing rate SOFR (Secured Overnight Financing Rate), thereby reducing the pressure on the use of reverse repos. SOFR, which uses US Treasuries as collateral, is a broad indicator of the cost of overnight borrowing.