Many pundits believe the Federal Reserve is counteracting its $120 billion per month Quantitative Easing (QE) purchases through its overnight Reverse Repurchase Program (RRP) that is taking in nearly $1 trillion a night in cash. This view could not be further from the truth, as QE creates bank reserves and RRP is used to stabilize money market rates.
When the Fed engages in QE, a bank reserve, which is created from customer deposits, is swapped by the Fed for an overnight Reserve Asset. A bank reserve, made up of Treasury securities, has an average duration of five years while an overnight Reserve Asset from the Fed matures every morning. By engaging in QE, the Fed reduces the duration of a bank reserve to an overnight reserve.
These overnight Reserve Assets are held at Federal Reserve member banks in an account for the bank, which traps them in the commercial banking system. Reserve Assets can be used to settle intra-bank transfers, as a deposit at Treasury auctions, and to lend against.
Since Reserve Assets are liabilities of the Fed and held at Federal Reserve member banks, only the Fed has the authority to remove them from the financial system. To remove a Reserve Asset from the financial system, the Fed reverses the QE process in what is referred to as Quantitative Tightening (QT).
QE is designed to increase the number of reserves in the banking system and QT is designed to decrease the number of reserves in the banking system, while overnight repurchase and reverse purchase agreements are used to stabilize money market rates.
When there are collateral shortages in the market, which means there is an insufficient number of Treasury Bills to back money markets and other demand deposits, the Fed intervenes and provides the necessary collateral through its overnight RRP facility.
To meet the collateral shortfall, the Fed offers to borrow cash for the night in exchange for an overnight Treasury security. As any borrower, the Fed even pays interest on the cash it borrows through its RRP facility at an annualized rate of 0.05%.
The confusion stems from the belief that the Fed is selling Treasury securities through its overnight RRP facility when it is lending Treasury securities. When the Fed lends Treasury securities through its overnight RRP, it maintains ownership of those Treasury securities which are returned the following morning when the loan matures.
When the Fed borrows cash and lends Treasury securities through its overnight RRP, a Reserve Asset is not removed from the financial system, which is why overnight RRP is not in any way, shape, or form Quantitative Tightening.
When determining ownership, which is a key point, QE changes the ownership of a bank reserve from a commercial bank to the Fed while QT changes the ownership of a bank reserve from the Fed to a commercial bank. A Repurchase or Reverse Repurchase Agreement does not change the ownership of a Treasury security.
While many believe the Fed’s overnight RRP is undoing QE, by understanding what each process is designed to do and if ownership is changed, it is very clear that overnight RRP is not a form of Quantitative Tightening.