Fed Overnight Reverse Repurchase Agreements: What Are They and How Do They Work?

The Federal Reserve has a variety of tools at its disposal to control the money supply, regulate interest rates, and stabilize the economy. One of these tools is the overnight reverse repurchase agreement, or ON RRP. This tool has been in use since 2013, but it gained renewed attention in 2021 as the Fed began to increase the interest rate on ON RRP transactions.

So what exactly is an ON RRP? Essentially, it`s a way for the Federal Reserve to temporarily remove money from the financial system. Here`s how it works:

– The Fed enters into an agreement with a counterparty (typically a large financial institution) to sell a security (usually a Treasury bond) with the understanding that it will buy the security back the following day.

– The counterparty pays the Fed a fixed interest rate (determined by the Fed) for the use of the security.

– The Fed`s temporary sale of the security and receipt of the interest payment removes cash from the financial system, which can help to reduce the supply of money and potentially raise interest rates.

Why would the Fed want to do this? One reason is to help control inflation. If there is too much money circulating in the economy, prices can rise rapidly, creating inflation. By temporarily removing some of that money through ON RRP transactions, the Fed can help to dampen inflationary pressures.

Another reason is to help maintain the Fed`s control over interest rates. When there is excess cash in the financial system, interest rates can fall too low, as there is more supply of money than demand for loans. By temporarily removing some of that cash through ON RRP transactions, the Fed can help to keep interest rates from falling too far.

It`s worth noting that ON RRP transactions are not a new tool for the Fed – they have been used on a relatively small scale since 2013. However, in 2021, the Fed began to significantly expand its use of ON RRP transactions, as it tries to manage the large amounts of cash flooding into the financial system due to government spending and stimulus efforts.

As of June 2021, the Fed`s interest rate on ON RRP transactions was 0.05%, and it was offering up to $80 billion in transactions per counterparty each day. These transactions are open to a wide range of institutions, including banks, money market funds, and government-sponsored enterprises.

While ON RRP transactions may not be the most exciting topic, they are an important tool for the Federal Reserve as it tries to manage the economy and keep inflation and interest rates under control. As always, the Fed`s decisions on these matters will have a ripple effect throughout the financial system, so it`s worth keeping an eye on what they`re up to.