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Arbitrage, liquidity and exit: the repo and federal funds markets before, during, and emerging from the financial crisis

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  • Morten L. Bech
  • Elizabeth Klee
  • Viktors Stebunovs

Abstract

This paper examines the link between the federal funds and repo markets, before, during, and emerging from the financial crisis that began in August 2007. In particular, the paper investigates the initial transmission of monetary policy to closely related money markets, pricing of risk, and liquidity effects, and then shows how these could interact if the Federal Reserve removes the substantial amount of liquidity currently in the federal funds market. The results suggest that pass-through from the federal funds rate to the repo deteriorated somewhat during the zero lower bound period, likely due to limits to arbitrage and idiosyncratic market factors. In addition, during the early part of the crisis, the pricing of federal funds, which are unsecured loans, indicated a marked jump in perceived credit risk. Moreover, the liquidity effect for the federal funds rate, or the change in the federal funds rate associated with an exogenous change in reserve balances, weakened greatly with the increase in supply of these balances over the crisis, implying a non-linear demand for federal funds. Using these analyses, the paper then shows simulations of the dynamic effects and balance sheet mechanics of liquidity draining on the federal funds and repo rates--a tool that might be used in an exit strategy to tighten monetary policy.

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File URL: http://www.federalreserve.gov/pubs/feds/2012/201221/201221abs.html
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File URL: http://www.federalreserve.gov/pubs/feds/2012/201221/201221pap.pdf
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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2012-21.

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Date of creation: 2012
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Handle: RePEc:fip:fedgfe:2012-21

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  1. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867-1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1.
  2. Niall Coffey & Warren B. Hrung & Asani Sarkar, 2009. "Capital constraints, counterparty risk, and deviations from covered interest rate parity," Staff Reports 393, Federal Reserve Bank of New York.
  3. Michael J. Fleming & Warren B. Hrung & Frank M. Keane, 2010. "Repo Market Effects of the Term Securities Lending Facility," American Economic Review, American Economic Association, vol. 100(2), pages 591-96, May.
  4. Leonardo Bartolini & Spence Hilton & Suresh Sundaresan & Christopher Tonetti, 2011. "Collateral Values by Asset Class: Evidence from Primary Securities Dealers," Review of Financial Studies, Society for Financial Studies, vol. 24(1), pages 248-278.
  5. Michael J. Fleming & Kenneth D. Garbade, 2005. "Explaining settlement fails," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 11(Sep).
  6. Johansen, Soren, 1995. "Identifying restrictions of linear equations with applications to simultaneous equations and cointegration," Journal of Econometrics, Elsevier, vol. 69(1), pages 111-132, September.
  7. Thornton, Daniel L., 2005. "Tests of the expectations hypothesis: Resolving the anomalies when the short-term rate is the federal funds rate," Journal of Banking & Finance, Elsevier, vol. 29(10), pages 2541-2556, October.
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Cited by:
  1. Jaime Marquez & Ari Morse & Bernd Schlusche, 2012. "The Federal Reserve's balance sheet and overnight interest rates," Finance and Economics Discussion Series 2012-66, Board of Governors of the Federal Reserve System (U.S.).
  2. Malik Shukayev & Alexander Ueberfeldt & Simona Cociuba, 2013. "Interest Rate Policy and Financial Regulation: How to Control Excessive Risk Taking?," 2013 Meeting Papers 584, Society for Economic Dynamics.

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