The Federal Reserve’s top markets official warned on Monday that a trend of U.S. money market firms converting funds from “prime” to “government-only” could be sharply reversed and harm the overall execution of policy when a new Fed tool is eventually dismantled.
In a speech on tools the U.S. central bank adopted to wrench interest rates from near zero in December, New York Fed markets chief Simon Potter warned money funds that one of those tools, an overnight repurchase facility known as ON RRP, is only temporary.
More than 100 funds have access to this facility that provides a short-term yield of 0.25 percent on cash. Many of them have begun in recent months to make the conversion from prime, which invests in a wide range of securities, to the narrower government-only structure ahead of an October deadline by the Securities and Exchange Commission for new controls on client redemptions in prime funds.
But if assets were to “grow significantly” in government-only funds, that could increase demand on the repo facility (ON RRP) since “most fund managers consider the facility to be a government investment,” Potter said.
“We would not want to see growth in government-only money funds if it were predicated on a mistaken impression that ON RRP would be around indefinitely and with high capacity,” he said. If the funds were to realize their error and “decline sharply, this could possibly lead to less efficient transmission of monetary policy.”
The Fed’s policy-making committee took the aggressive step in December of backing the ON RRP facility with up to $2 trillion in bonds, which many investors took as a signal that it would remain in place for some time. But the Fed has long said the tool would only be used as long as it was necessary to keep lifting rates off the floor.
While Potter raised a possible red flag, he added that the goal was to avoid exacerbating any possible risk of investor runs in money funds, as happened in the 2008 crisis.
“We’re not going to have a view point as to what money funds should do,” he said at the School of International and Public Affairs at Columbia University. “We’re just trying to look at how we’re going to implement policy … where we’re trying to basically do no harm.”
The key short-markets where the Fed conducts monetary policy have been calm since the mid-December rate hike, relative to volatility in global bond and equity markets, which have sold off through January and February.
Potter, who runs the team that implements U.S. monetary policy, said he was “extremely pleased” that the new tools proved to have “excellent control” over a handful of money market rates.
The Fed in December raised its key rate from about 0.36 percent from about 0.12 percent, the first policy tightening in nearly a decade. It aims to keep tightening this year, though the risk of a global economic slowdown is expected to slow the pace.