Arbitrage, Liquidity and Exit : The Repo and Federal Funds Markets Before, During, and After the Financial Crisis

This paper examines the interplay between the federal funds and repo markets, two key markets for monetary policy implementation, before, during, and after the financial crisis that began in August 2007. Overall, the results suggest that the federal funds rate communicated policy to the repo market quite well in the pre-crisis period, as well as during the first stages of the crisis. However, coincident with the introduction of a target range for the federal funds rate of 0 to 1/4 percent and interest on excess reserve balances, the relationship between these rates deteriorated, possibly due to counterparty credit concerns. Moreover, as the level of reserve balances increased dramatically, the effect of changes in these balances on market rates became muted. While before the crisis a $10 billion increase in supply of reserve balances pushed the federal funds rate down by 5 basis points, after the crisis the same increase results in just a 0.1 basis point decline in the federal funds rate. Consequently, our policy simulations suggest that a large-scale draining of reserve balances, such as reverse repos with primary dealers and other counterparties which simultaneously drain reserve balances and supply high-quality collateral to the repo market, might exert weak upward pressure on the federal funds and repo rates at high levels of balances, but should exert strong upward pressure at lower levels. Our simulations also show that the effect of these large-scale reverse repos might be somewhat weaker on the repo rate than on the federal funds rate