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Fed: Central Bank reverse repo transactions and tapering management

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A repo is a way for the Fed to add temporary liquidity to the market, whereby the central bank’s open market desk purchases assets from banks for a short period of time, usually overnight, before reversing the deal. Basically, it is a cash loan to the bank guaranteed by the assets purchased. A reverse repo is logically the opposite of the situation where the bank gives a short-term, guaranteed loan to the central bank. Reverse repos are a sign of excess liquidity in the system; this means that banks have money left over after they meet their obligations and invest and lend to what they are comfortable with.

 

The New York Fed conducts overnight reverse repo transactions every day to help keep the federal funds rate within the target range set by it. In a macro example of RRPs, the Fed uses repos and RRPs to stabilize lending markets through open market operations (OMO). The RRP transaction is less used by the Fed than a repo because when a repo is short it puts money into the banking system, while an RRP borrows money from the system when there is too much liquidity. The Fed runs RRPs to maintain long-term monetary policy and ensure capital liquidity levels in the market.

 

A steady rise in reverse repos this year tells the Fed that banks no longer need their help and can reduce liquidity addition measures, originally intended as a short-term response to a crisis, without any intervention. A huge jump in reverse repo volume means the financial system is now self-supporting after a lot of help from the Fed.

 

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As of November, the Fed is reducing its asset purchases by $15 billion tranches. Depending on the situation, it may be possible to reduce asset purchases more quickly. It seems necessary to remove reserves from the banking system through reverse repo operations to keep the federal funds rate in positive territory. The reverse repo volume has exceeded $1.5 trillion. How the Fed manages its securities purchases, how it uses the reverse repurchase agreement market, and policy rate projections will be crucial.

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