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Daily take-up at the overnight reverse repo (ON RRP) facility increased from less than $1 billion in early March 2021 to just under $2 trillion on December 31, 2021. In the second post in this series, we take a closer look at this important tool in the Federal Reserve’s monetary policy implementation framework and discuss the factors behind the recent increase in volume.
In yesterday’s post, we presented a stylized view of the Fed’s implementation framework for monetary policy, in which (i) the Federal Open Market Committee (FOMC) communicates the stance of monetary policy through a target range for the federal funds rate, (ii) interest on reserve balances (IORB) is a key tool, and (iii) an ample supply of reserves ensures that the interest rate paid on banks’ reserve balances maintains the effective federal funds rate (EFFR) within the target range. However, in the United States, banks are only a part of the money market ecosystem—nonbank financial institutions make up a significant share of lending activity.
As a result, the FOMC employs another tool called the ON RRP facility, which is available to a wide range of money market lenders. This facility is particularly important for monetary policy implementation in periods when reserves are elevated. As reserves grow, banks’ willingness to take on additional reserves diminishes, and they reduce the rates they pay for deposits and other funding. In this environment, market rates trade below the IORB rate because nonbank lenders are willing to lend at such rates. For example, the Federal Home Loan Banks (FHLBs), which are important lenders in the fed funds market and not eligible to earn IORB, are willing to lend at rates below the IORB rate rather than leave funds unremunerated in their accounts at the Fed. To provide a floor under the fed funds rate, the FOMC introduced the ON RRP facility.
In concept, the ON RRP facility acts like IORB for a set of nonbank money market participants. Through the ON RRP facility, eligible institutions—money market funds, government-sponsored enterprises, primary dealers, and banks—can invest overnight with the Fed through a repurchase agreement (repo).
By setting the ON RRP rate, the FOMC establishes a floor on the rates at which these institutions are willing to lend to other counterparties. The floor improves these institutions’ ability to negotiate rates on private investments above the ON RRP rate and provides an alternative investment when more attractive rates are not available.
In periods when the EFFR is close to or above the IORB rate, we would not expect the ON RRP facility to see much take-up as money market participants have access to alternative investments at more favorable rates. This can be seen in the charts below. The first chart shows that as reserves steadily declined during the monetary policy normalization process, in 2018 and 2019, the EFFR increased relative to the IORB rate. The second chart shows that as the EFFR-IORB spread increased, take-up at the ON RRP facility decreased and was almost always very small, until the pandemic.
The Spread between the EFFR and the IORB Rate Tends to Decrease when Reserves Increase
Take-up at the ON RRP Tends to Be Larger when the Spread between the EFFR and the IORB Is More Negative
In contrast, when reserves are plentiful and the EFFR moves closer to the bottom of the fed funds target range, the rate offered at the ON RRP facility becomes more attractive relative to alternative investments and we would expect to see an increase in take-up at the ON RRP facility. (The available supply of safe investments like Treasury bills can also influence the EFFR, as suggested in this Liberty Street Economics post.) At such times, the ON RRP facility is particularly important for the control of the EFFR. This is indeed what happened from 2013 through 2017, and in 2021 as well. As reserves have reached unprecedented levels over the last year, so has take-up at the facility.
An ON RRP transaction—which is economically similar to a secured loan—does not change the size of the Fed’s balance sheet but does shift the composition of the Fed’s liabilities. For instance, when a money market fund reduces overnight deposits with a bank and directs those funds to the ON RRP facility, the increase in the ON RRP facility decreases reserve balances held by banks at the Fed. The ON RRP facility, thus, allows the Fed’s liabilities to be more broadly distributed among money market participants.
This broader distribution of Fed liabilities is particularly useful in environments where the FOMC uses asset purchases to stimulate the economy, and reserves rise as a result. Since reserves can only be held by banks, substantial growth in reserves can put pressure on bank balance sheets. Therefore, when the ON RRP facility grows it reduces these pressures by offering liabilities that can be held by a broader set of financial market participants, supporting the FOMC’s efforts to stimulate the economy through asset purchases.
The next chart shows that an increase in take-up at the ON RRP facility moderates the growth in reserve balances. Hence, when ON RRP take-up is high, as it is today, the supply of reserves is lower than it would be absent the ON RRP facility, and banks’ balance sheets are less impacted.
ON RRP Take-up Reduces the Supply of Reserves, Everything Else Equal
The Fed began testing ON RRPs in September 2013 and then transitioned the ON RRP facility to an implementation tool around the “lift-off” of interest rates in December 2015. Since that time, the EFFR has only printed below the target range once, at the end of 2015.
As shown in the next chart, the ON RRP facility has been very effective at providing a floor under the EFFR even as aggregate reserves have continued to grow in 2021, rising above the unprecedented level of $4 trillion in July.
ON RRP Facility Has Been an Effective Floor under the EFFR
To circle back to the beginning of the post, in the recent environment of abundant reserves, the ON RRP facility is working as expected. It is providing a floor under the fed funds rate and moderating the growth in reserve balances as the Fed continues to provide support to the U.S. economy.
Gara Afonso is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
Lorie Logan is an executive vice present in the Bank’s Markets Group and manager of the System Open Market Account for the Federal Open Market Committee.
Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.
William Riordan is an assistant vice president in the Bank’s Markets Group.
Patricia Zobel is a vice president in the Federal Reserve Bank of New York’s Markets Group and deputy manager of the System Open Market Account for the Federal Open Market Committee.
How to cite this post:
Gara Afonso, Lorie Logan, Antoine Martin, William Riordan, and Patricia Zobel, “How the Fed’s Overnight Reverse Repo Facility Works,” Federal Reserve Bank of New York Liberty Street Economics, January 11, 2022, https://libertystreeteconomics.newyorkfed.org/2022/1/how-the-feds-overnight-reverse-repo-facility-works/.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Sometime in the spring of 2020, Sam O’Leary’s phone began ringing off the hook.
The callers were managers from the auto and aerospace industries. They were all seeking help from his industrial 3D printing business in Germany, SLM, in producing vital parts that were suddenly becoming scarce as the Covid-19 pandemic disrupted international shipping.
“I didn’t do a single day away from the office,” says O’Leary, who took to showing off the company’s specialised machines to clients over video calls. His customers’ worries were always the same, he says: “I’ve got a massive problem, I need to de-risk, I need to reshore.”
SLM’s customers had hitherto used its technology for niche applications, such as producing gooseneck brackets for planes and brake callipers for performance vehicles.
But, despite the increased cost and complexity of 3D printing metal components, they turned to the technology for more commonplace parts — such as hinges that keep regular car seats in place.
So, while many other industrial businesses saw their order intake slow to a standstill, revenues at the Lübeck-based company — whose shares had fallen to record lows before the pandemic hit — grew by more than a quarter in 2020.
Sales were on track to have increased by a similar amount in 2021. For 2022, O’Leary expects SLM’s sales to grow by 40 per cent.
High-profile disruptions to global supply chains in the past couple of years — including the temporary blockage of the Suez Canal, floods and fires in Texas and Japan, as well as ongoing semiconductor production bottlenecks — have led to similarly rosy forecasts for the rest of the so-called “additive manufacturing” sector.
Last year, a study by Lux Research estimated that the market for 3D printed parts, which was worth $12bn in 2020, would grow to well over $50bn by the end of the decade.
Governments across the world have sought to address how, and where, components are made. In Germany, the recent chronic shortage of semiconductors led to millions fewer cars being produced than customers wanted to order. As a result, it is one of many countries to have pledged to support the “reshoring” of crucial component manufacturing to protect their economies.
But, despite such enthusiasm, evidence increasingly points to the fact that businesses like SLM are serving a small market.
A survey of European companies conducted by EY in the early spring lockdowns of 2020 found that more than four-fifths were considering bringing their supply chains closer to home. When the same survey was conducted in April last year, however, that view was shared by just 20 per cent of respondents.
Similarly, only 15 per cent of the multinational companies surveyed by the Association of German Chambers of Industry and Commerce (DIHK) said they would relocate production.
Their stance was echoed by sports goods group Adidas. Just five years ago, the company launched a scheme to build factories in Germany and the US that would use local materials and advanced manufacturing techniques, such as 3D printing, to produce bespoke trainers for nearby customers.
It had to all but abandon this plan as the Covid-19 pandemic began. But, after supply chain disruptions cut Adidas’ revenue growth by around €600 million in the three months to the end of September 2021, boss Kasper Rorsted was adamant that he had not changed his view on reshoring manufacturing.
“We have approximately 800,000 people deployed in our [suppliers’] factories,” he said in November. “It is an illusion to believe that you can move an industry that has grown over 30 years in Asia, to a very sophisticated industry, to some regions.”
Even if that was theoretically possible, Rorsted added, raw materials would still need to be sourced from around the world to produce the parts, making the prospect of reshoring a “total illusion”.
“You wouldn’t even be able to find the people [that would need to do the work currently being done in Asia],” he said.
Economists in Germany are also unconvinced.
“If the EU were to decouple even partially from international supply networks, this would considerably worsen the standard of living for people inside the EU as well as for its trading partners, and should thus be avoided by all means,” warns Alexander Sandkamp. He is one of the authors of a study by the Kiel Institute for the World Economy that suggested that regionalising production would cost Europe hundreds of billions of euros.
The recent flood disasters in Germany, which cost the country €40bn, according to insurance group Munich Re, was further proof that “shocks can also occur on our doorstep,” Sandkamp adds.
Even SLM’s O’Leary is quick to add a caveat to his company’s bullish forecast.
“We work primarily with regulated industries,” he says. “So, if you’re in an aerospace supply chain . . . you don’t just buy a 3D printer and say: ‘OK, well, I’ve decided to move away from my supplier wherever [they are] in the world and I’m going to do this in-house’.”
A recent development programme with a major UK aero-engine manufacturer, he adds, took two years to get up and running, due to the time needed to install the necessary machines on-site and get the necessary approvals from Britain’s Civil Aviation Authority.
“The demand is definitely increasing,” says O’Leary. “But there’s also a reality in that this is a technology and a change that is regulated and takes time.”
Additional reporting by Olaf Storbeck
In October last year, Volvo Group unveiled the world’s first vehicle made using “green” steel. The autonomous electric truck weighed eight tonnes and was designed for use in quarries and mines.
It was the result of an industrial partnership between Swedish steelmaker SSAB, the state-owned electricity generator Vattenfall, and iron-ore miner LKAB. Their aim was to make the first steel free of fossil fuel by replacing the coking coal traditionally used in its manufacture with green hydrogen.
The partnership, dubbed “Hybrit”, is at the cutting-edge of European industry efforts to develop more energy-efficient, low-carbon manufacturing techniques.
Many initiatives were already under way before the coronavirus hit, but the pandemic has focused industrial leaders’ minds on the importance of reshaping and strengthening supply chains, and coping with longer-term challenges — in particular, climate change.
“It is no longer about the lowest cost producer, it is about resilience in your supply chain,” says Stephen Phipson, chief executive of British trade body, Make UK.
Manufacturing executives in the UK, he points out, are re-evaluating ‘just-in-time’ manufacturing processes and how much inventory to hold in future to ensure greater resilience. The importance of skills has also moved up the agenda, especially as companies battle to attract and maintain workers after the pandemic, which has left many short of staff.
But business leaders caution that wholesale transformation will not happen overnight.
A survey by McKinsey last November underlined the challenges. In a previous survey, in May 2020, most companies stated that they planned to pursue several paths to improve supply-chain resilience, including diversifying supply bases. But, in practice, by the end of 2021, most had mainly increased their inventories.
The more recent survey found that 61 per cent of companies had increased inventory of critical products and 55 per cent had taken action to ensure they had at least two sources of raw materials. Only 11 per cent had “nearshored” production, to avoid the risks of disruption from geographically remote suppliers.
Duncan Johnston, UK manufacturing leader at Deloitte, says: “Changing things in manufacturing takes time. You can’t change what was a global supply chain into something that is more near-shored or UK-centric very quickly”.
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The same, he says, is true of sustainability ambitions. While companies have done some thinking about it, they have not yet “really embarked on the substantial journey that is needed to reduce carbon emissions in the UK economy”.
Manufacturers face several challenges along the way. Apart from reducing the emissions in their own processes, they need to consider those in their supply chain. They need to find new ways to power their activities and, in some cases, such as the automotive sector, completely re-engineer their products.
Heavy manufacturing industries, such as steel and cement, are among those at the forefront of efforts to decarbonise countries’ economies. Outside of power generation, the iron and steel sector is the largest industrial producer of carbon dioxide. It accounts for 7 per cent-9 per cent of all direct fossil fuel emissions, according to the World Steel Association.
To meet global climate and energy goals, the steel industry’s emissions must fall by at least half by the middle of the century, according to the International Energy Agency. Achieving such a reduction will require more than incremental improvements in the efficiency of traditional blast furnaces.
“We have come to a point where, in terms of efficiency improvement efforts, there is not much more room left,” says Martin Pei, chief technical officer at SSAB. “It is really breakthrough technology that we are looking at now.”
In the blast furnace process, companies use carbon to take oxygen from iron ore to get iron. SSAB will instead use clean hydrogen gas, produced in a facility called an electrolyser powered by Sweden’s abundant renewable electricity. The output will be a solid intermediate, called sponge iron, which goes into an electric arc furnace, where it is mixed with scrap and refined into steel.
The successful production of Volvo’s first heavy-duty truck shows that the “whole value chain works,” says Pei.
SSAB has estimated that metal from its hydrogen-based process will, at least initially, be 20-30 per cent more expensive than conventional production. Pei, however, says that customers are keen and that demand for greener steel is growing as more and more companies commit to decarbonising their supply chains.
Policymakers will need to play their part, too, in helping manufacturers transition to a low-carbon economy. For Europe’s steel industry to switch en masse to hydrogen, for example, would require a massive expansion of renewable power. State support would be needed to fund the necessary investment in expanding power grids and other infrastructure to accommodate the transformation to low-carbon economies.
Hydrogen is a prime example. The EU and the UK have both published ambitious plans to develop a hydrogen economy but obstacles remain to making this a commercial reality.
For example, says Phipson, the UK has a “very small innovative sector on hydrogen . . . the challenge is to scale that up”. Britain, he adds, is very good on innovation and research funding but what is needed is “scale-up capital”.
As for funding sources, he says: “There is a big commitment from companies to use private capital but the government also needs to play its part.”
Transforming the workforce to deal with this transition is another concern. Even before the pandemic, manufacturers were worried about the effects of an ageing workforce and how to attract younger talent with more digital skills.
“We don’t know any manufacturing business that has as much in the way of digital skills as they would like,” says Johnston.
Those worries have grown, with many employers emerging from the pandemic with even more unfilled jobs. Phipson wants to see more action from the government on this front, as well.
“[It] needs to get more ambitious about its skills,” he believes. At the moment, the skills shortage is a “drag on growth”.
Ayatollah Ruhollah Khomeini once said the purpose of the 1979 revolution in Iran was to promote Islam, not the economy. Focusing on the latter would reduce human beings to animals, according to the founder of the Islamic republic.
More than four decades later, the regime’s ideology and hostility to the US remain intact but the economy is very much at the forefront of leaders’ minds. New president Ebrahim Raisi has sought to assure Iranians that his priorities were tackling economic woes and boosting their welfare.
The solution has been adopting a “resistance economy” against sanctions imposed by Washington, which accuses Tehran of developing the atomic bomb and fomenting terror operations in the Middle East. Iran can foil hundreds of US punitive measures by focusing on its domestic market; curbing its reliance on imports; increasing exports of non-oil goods to neighbours; and selling more oil to China.
Iran’s leaders say the economy has started growing again as a result. Indeed, the Islamic republic has weathered some of the biggest economic and military threats in recent years, a resilience partly reflected in the World Bank’s latest report.
In its economic forecasts published last week, the international lender said Iran’s economy was “gradually recovering following a lost decade (2011-2020) of negligible economic growth”.
After a two-year contraction, Iran’s gross domestic product grew by 6.2 per cent year on year in the period from March to May, the first quarter of the country’s 2021-22 fiscal year. This was thanks to expansion in oil and services sectors and less stringent Covid-19 restrictions.
Meanwhile, oil production — Iran’s lifeline — is rising: it reached 2.4 mbpd in January-November 2021, although it is still behind the pre-sanction level of 3.8 mbpd in 2017, the bank said.
The positive developments have emboldened Tehran at a time when its diplomats are negotiating with world powers in Vienna to resurrect the 2015 nuclear deal, from which the US under Donald Trump withdrew in 2018. Iran promises it will roll back its huge nuclear advances only if the US lifts all sanctions first and guarantees no other US leader would abandon the deal. Economic resistance would continue if not.
Hardliners in Tehran, who control the Islamic republic’s most powerful bodies, shrug off warnings at home that such a stance could dearly cost the country as well as the regime in the long run.
The World Bank report noted that GDP growth was “from a low base”. It said real GDP in the previous financial year ended in March 2021 stood at the same level as a decade ago “while the country forewent the demographic window of opportunity (a highly educated young population)”. The latest economic rebound “only marginally reduced” the income gap with economies in the Gulf, the report noted.
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In Iran, patience is running thin. Iranians say numbers are meaningless when their purchasing power is being eaten away with 43.4 per cent inflation (even though it has started going down). Inflation coupled with high unemployment and fluctuations in the currency and capital markets is fuelling pessimism.
The government’s plans to further cut subsidies on basic commodities and medicine have heightened inflationary fears. Masoud Mir-Kazemi, Iran’s vice-president for budget affairs, said Iran could at most earn a net income of $16bn in petrodollars next financial year, just enough to import basic commodities and pay civil servants. “We are under sanctions and it’s impossible” not to slash subsidies, he said last week.
But for a regime that came to power through street protests, fears of history repeating itself, this time against the Islamic republic, are never far. Demonstrations are no longer sparked by the educated middle class to demand more social and political freedoms. Recent protests have been mostly over economic woes, whether caused by the government or by a severe drought.
Mehdi Asgari, a member of parliament opposing a cut in subsidies, said last week that more than 10m families struggled with poverty “and millions more [were] heading” in that direction. “They no longer can afford meat and rice and now you want to take away their bread and cheese, too?”
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