Money Market Segmentation and the Transmission of Post-crisis Monetary Policy

Abstract

This paper studies the transmission mechanism of the post-crisis interest rate policy. In particular, we are interested in explaining an upward regime shift in the spreads between interest on reserves (IOR) and overnight funding rates in Jan 2018. While traditional theories would understand such a regime shift through the lens of balance sheet constraints or convenience yield, we propose a theory that builds around the segmentation of U.S. money markets. By assuming that investors face short-sale constraints and have heterogeneous access to the Fed's interest rate policy instruments, we show that the equilibrium interest rate is a non-linear function of the debt-to-reserve ratio due to limited participation. When the debt-to-reserve ratio is low, local debt supply shocks can be absorbed by investors at the corresponding policy rate. But when the debt-to-reserve ratio is high, a small debt supply shock can generate a large spike in the equilibrium rate. Using data on repo transactions collected from SEC filings, we find that the FICC's sponsored repo reform in Jan 2018 significantly increased the repo volume inter-mediated by large banks and drained out the residual cash supply in the RRP facility. Consistent with our predictions, the increased repo volume and the Fed's balance sheet normalization jointly created an environment where window-dressing shocks can generate large rate spikes. Our results suggest that keeping an abundance of reserves is essential for implementing the interest rate policy and building a resilient funding market.

Keywords: repo, monetary policy, market segmentation, financial inter-mediation, short-term interest rates

JEL Classification: E52, E43, G21, G23, G12