[W]e communicated in our minutes that the committee has an intention to make sure that ... overnight repos are available in large quantity at liftoff to ensure that we have a smooth liftoff, that there'll be an elevated level of provision of overnight RRP. However, it is our expectation and plan that fairly quickly after liftoff, we will reduce the level of the overnight RRP facility, and we have a variety of ways in which we can do that.

In sum, arbitrage activities by banks, complemented as needed by ON RRP operations, should cause a higher IOER rate to lead to higher levels of market rates. However, if the pressure on market rates from the Feds administered rates turns out to be insufficient, the Committee has a range of other tools including term deposits, term RRPs, and asset salesthat could be used to help tighten the stance of policy. Given the array of tools at our disposal, I am confident that the FOMC can adjust and control short-term interest rates as needed to foster its objectives of maximum employment and price stability. Given the range of available tools, I am confident in our ability to raise short-term interest rates from the zero lower bound when the time to do so arrives. Nevertheless, the FOMC is prepared to adjust the details of its approach to policy normalization in light of economic and financial developments and the Desk stands ready to innovate in order to efficiently and effectively implement policy consistent with the Committees directive.

The Committees normalization principles and plans do not detail the manner in which IOER as a primary tool would be combined with supplementary tools such as ON RRPs to move the fed funds rate into the target range. However, as reflected in the minutes to the July FOMC meeting, most Committee participants anticipate that, at least initially, the IOER rate could be set at the top of the target range for the funds rate, and the ON RRP rate could be set at the bottom of that range. This is also consistent with the views of many market participants as reflected in surveys conducted by the Desk. [A]s the Chair noted during her September press conference, the Committee expects that the effective fed funds rate may vary within the target range and could even move outside of it on occasion. For example, the effective rate could move outside the target for a day or two around key financial reporting dates, such as quarter-ends, when some banks marginal balance sheet costs are particularly high. However, such transitory movements should have no material effect on financial conditions or the broader economy. What matters for policy transmission is the predictability that on most days money market rates will be close to the target range set by the FOMC.

Our analysis has found that, offered at a spread of 20 basis points to the IOER rate, ON RRPs have kept overnight repo rates above where they would otherwise have been, in part by influencing the bargaining power of our counterparties. So what are the benefits of moving from a structure with individual caps alone to one with an aggregate cap as well? One benefit is that, in limiting the overall take-up but not individual take-up, an aggregate cap should produce a more efficient allocation of usage among counterparties than would a system of individual caps. Further, an aggregate cap should better balance efficient control of money market rates under normal conditions with the risk of a destabilizing surge in use of the facility in times of stress. The reduced risk of a surge in use in a system with an aggregate cap comes from the fact that take-up across counterparties is not perfectly correlated. As a result, an aggregate cap that binds at some frequency can be set below the sum of individual caps that would bind for at least one of the counterparties at the same frequency. The aggregate cap also raises the individual bargaining power of counterparties relative to a system of lower individual caps, since in normal times counterparties can be relatively certain that larger bids at the ON RRP facility will be filled. However, the possibility that the aggregate cap could bind even in only limited circumstances may undermine this effect on bargaining power.

“I don’t think it would have to be that large of a program. Possibly several hundred billion would be enough,” Bullard said, referring to the Fed’s overnight reverse repurchase facility, which it has been testing since September.

“If that didn’t work, the committee could revisit that and increase the size of the program if we thought that was necessary,” Bullard said in an interview yesterday with Kathleen Hays on Bloomberg Radio in Jackson Hole, Wyoming.

“We may not need the reverse repo facility at all, because if we raise interest rates and the funds rate goes up with it, why would we need to introduce other dimensions?” said Philadelphia Fed President Charles Plosser in a Bloomberg Radio interview with Kathleen Hays in Jackson Hole, Wyoming.

“I think it’s presumptive to say that we will” need to utilize the reverse repo facility, “because I don’t think we know whether we will or not,” Plosser said. “I think many members are worried about the reverse repo program becoming too big an intervention into money markets, and to the plumbing of our money-market system. We want to be cautious about creating a facility that we can’t get ourselves out of.”

So we've indicated that the main tool we will use is the interest rate we pay on overnight reserves. The overnight RRP facility that you refer to I think of is a backup tool that will be used to help us control the federal funds rate, to improve our control over the federal funds rate. I think it's a very useful and effective tool. We have gleaned that from the initial testing that we have done.

But as you mention, we do have concerns about allowing that facility to become too large or to play too prominent a role and for precisely the reason that you gave: If stresses were to develop in the market, in effect it provides a safe haven that could cause flight from lending to other participants in the money markets.

So two tools that we can use and are discussing to control those risks, one would be to maintain relatively large spread between the interest rate we pay on overnight reverse RPs, and the interest rate on excess reserves, the larger that's spread, the less use that facility will be. Also, we can contemplate limits on the extent to which it can be used, either aggregate limits or limits that would apply to individual participants, and all of that is figuring into our discussions.

Let me be quick to add that one negative, collateral impact of engaging in reverse repos is that during a period of heightened financial risk, investors might flee to the reverse repo market. This would provide a safe asset for investors, but might also encourage runs from higher-risk, short-term private debt instruments. This would have the potential to create significant private sector financing disruptions during times of stress. Presumably, capping the size of the reverse repo facility could help limit the impact.

Two issues with the overnight reverse repo rate warrant careful consideration. The first is how big a footprint the facility should have in terms of volume. To the extent that the overnight RRP rate were set very close or equal to the interest rate on excess reserves (IOER) without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further development of the shadow banking system. If this were deemed undesirable, this would argue for a wider spread between the overnight RRP and the IOER in order to reduce the volume of flows into the facility.

The second issue is the facility’s potential impact on financial stability. In particular, would such a facility make financial instability less likely? And, when financial stress did occur, would such a facility amplify or dampen financial strains?

On the first point, it seems that such a facility would tend to make financial instability less likely. The overnight RRP facility allows us to make a short-term safe asset more widely available to a broad range of financial market participants. The provision of short-term safe assets by the official sector might crowd out the private creation of runnable money-like liquid assets. This might enhance financial stability by reducing the likelihood of a financial crisis.

However, if a financial crisis were to occur, the existence of a full allotment, overnight, RRP facility might exacerbate instability by encouraging runs out of more risky assets into the facility. That is because the supply of a full allotment facility would be completely elastic at the given fixed rate. Money market mutual funds and other providers of short-term financing could rapidly shift funds into the facility away from assets such as commercial paper that support the private sector. In contrast, in the current regime, when financial crises lead to flows into less risky assets, their interest rates fall, limiting the appetite for these less risky assets. Consequently, under a full allotment setup, runs could be larger and these runs could exacerbate the fall in the prices of riskier assets. Note that the risk here is how quickly financial flows could reverse from one day to the next, not the average level of take-up of the facility over time.

YELLEN: So this fixed rate overnight reverse, repurchase facility is one where we're essentially borrowing from non-banking -- from -- from entities other than banking organizations. We're offering the to pay a low, fixed rate, and are offering our counter- parties in return for their loans to us, collateral which comes in the form either of treasury or agency mortgage backed securities.
And we're engaging in this program. As you mentioned, this is something technical. But we want to be table to firmly control short- term money market rates when the time ultimately comes, which it's not -- it's probably a long way off, but when the time comes we do want to tighten monetary policy and raise our target for short-term interest rates. We would like to be able to execute that in a very smooth way so that we have good control over the level of short-term interest rates.
And the -- paying interest on reserves, that's something that is one tool we will be using to boost when the time comes, the level of short-term rates. But using this new facility can also help us gain better control, I think, than we could through interest on reserves alone.
So, at the moment, we have been gaining experience with developing this facility, making sure we can smoothly execute these transactions with a range of potential lenders.
We have put limits both on the magnitude of loans that we will be willing to take on, and what we're paying, as you mentioned, the limit so far has been five basis points. We're pleased by what we're seeing about our ability to carry out the exercises, and it's part of prudent planning that the Fed has been doing for quite some time.
HAGAN: And what about the dollar volume?
YELLEN: It varies from day-to-day depending on how much interest there is in the markets. It's up to the markets to decide. We've typically had limits on the amount that any one firm we lend to us overnight.
HAGAN: It was $3 billion. Now it's up to $5 billion?
YELLEN: Yes. I think there were days at the end of the year -- given the pressures that existed toward the end of the year when I believe the volume rose to $30 billion or $40 billion. But I can get you exact details on the quantities if you would like further information.
HAGAN: What are the monetary policy effects of raising this offer rate beyond other range set than the FOMC’s resolution?
YELLEN: Well, these are very, very low rates.
HAGAN: Right.
YELLEN: And so we're not raising rates by doing this. We're only going up to five basis points. We're paying 25 basis points on interest on reserves and there's really only any take up at times when there would be, you know, pressure for unusual reasons for rates to fall to below that.
But we're not pushing up the general level of short-term rates with this facility at this time.

Williams is a strong supporter of the Fed's bond-buying program. On Tuesday, he said he believes that the Fed needs to do more to prove it is committed to keeping short-term rates low as long as needed to support the recovery.

Most importantly, he said, the Fed should give better guidance on what would induce it to raise rates once the U.S. unemployment rate falls to 6.5 percent, the level at which the Fed said has said it would consider an interest-rate hike.

…

"Most participants" at the Fed's latest policy-setting meeting thought lowering the rate was "worth considering at some stage," according to minutes of the meeting released last month.

Critics worry whether money markets can still function if rates fall to zero; indeed, over the years, the Fed has considered and rejected the idea of reducing the rate in part because of that very concern.

But a new central bank tool blunts that risk, Williams said on Tuesday.

Known as a fixed-rate full-allotment reverse repo facility, the tool has been touted as a way to mop up excess cash in the financial system once the Fed needs to start raising rates.

But it could also be helpful should the Fed decide to lower the rate it pays to banks, Williams said.

"We do have this ability through this reverse repo that's been tested by the New York Fed that basically makes sure we can control short-term interest rates even if we ... lowered the interest on reserves closer to zero,"

The effectiveness of an overnight, fixed-rate, full-allotment facility in helping to control overnight money market rates will depend on a range of factors, including whether a sufficiently wide set of non-bank counterparties has access to the facility… More counterparties could certainly be added, and we’re in the process of considering how best to proceed. The efficacy of the facility will also depend on factors such as the regulatory and balance sheet constraints of counterparties and the level of competition in the markets. However, the facility’s value in terms of monetary policy implementation wouldn’t necessarily be determined by the amount of usage. If the facility increases bargaining power for market participants, it could conceivably provide an effective floor for short-term rates, giving the Desk tighter control of money market conditions even with usage of the facility that’s low on average.

There are several reasons motivating our interest in developing {an overnight fixed-rate reverse repo} facility. First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates. .. These reverse repos would be available to an expanded set of counterparties that includes many of the money market lenders who are ineligible to earn the interest on excess reserves (IOER), such as GSEs and a number of money market funds. Depending on the facility rate, these lenders who cannot earn the IOER rate might get a better rate by investing in the overnight RRPs compared to lending to banks or to broker dealers. This competitive effect could, in and of itself, put a stronger floor on money market rates.

Second, this new facility is also likely to reduce the volatility of short-term interest rates. If a lender that cannot earn the IOER rate has an unexpectedly large amount of funds to invest, this lender currently may have to accept an unusually low interest rate. But with the overnight reverse repo facility in place, this lender could lend as much funds as desired to the facility at a fixed rate and this should reduce the downward pressure on money market rates. By tightening control and reducing the volatility of short-term rates, such a facility should reassure investors that the Federal Reserve has sufficient tools to manage monetary policy effectively even with a very large balance sheet.

In coming months we will test the facility with two goals in mind. First, we want to be assured that there are no glitches operationally with somewhat higher transaction volumes than in previous tests, that we can accept cash from a larger array of counterparties, post collateral in the tri-party repo system and reverse the transactions each day smoothly. Second, while the limited size of the operations during this exercise will prevent the operations from having a significant impact on market rates, we will observe how the facility impacts individual investor demand relative to other market rates. Additionally, we can see how sensitive that demand is to changes in market conditions such as quarter-end that increase the demand for safe assets. These observations will give us some insight into how the facility could affect the entire constellation of money market rates. Only by testing and learning will we be able to assess how best to use the facility.

On reverse repos, we have already successfully run small-scale operations using Treasury and agency debt as collateral with primary dealers. However, that leaves two significant steps still to take in preparing the tool. One is developing the capacity to use our MBS holdings as collateral. Work in that area is nearly complete, and we will likely conduct some small-scale operations with MBS collateral in a month or so to exercise that capability. The other step is expanding the set of counterparties that we use for such operations. Earlier today, we published criteria for money market mutual funds to become eligible to participate in reverse repo operations, which was a first and important step in that direction. We are currently working with other types of firms to assess their potential participation in the program, as well. Our expectation is to have arrangements in place and to be ready to transact with some non-dealer firms by the end of the second quarter. This expansion of counterparties is important for boosting the capacity of the program.