Foreign Reserve Management and U.S. Money Market Liquidity: A Cost of Exorbitant Privilege

65 Pages Posted: 8 Sep 2022

See all articles by Ron Alquist

Ron Alquist

Financial Stability Oversight Council, U.S. Treasury

R. Jay Kahn

Board of Governors of the Federal Reserve System

Karlye Dilts Stedman

University of North Carolina (UNC) at Chapel Hill, College of Arts and Sciences, Department of Economics; Federal Reserve Bank of Kansas City

Date Written: September 2, 2022

Abstract

We show theoretically and empirically that the dollar’s status as the global reserve currency can lead to economically significant changes in U.S. money market liquidity. We develop a model in which U.S. money market spreads respond to foreign central banks’ exchange-rate management decisions. Foreign central banks remove liquidity from U.S. money markets and cause spreads to widen by selling Treasuries to supply liquidity to their financial systems. Our analysis focuses on the major oil exporting countries with fixed exchange rates because their foreign-exchange market interventions are straightforward to characterize. Our regression analysis shows that shifts in the central banks’ demand for dollar liquidity related to oil price volatility are associated with significantly higher overnight spreads in domestic money markets. A one-standard deviation increase in the demand for dollar liquidity by a central bank in an oil-exporting country leads, on average, to three billion dollars of Treasury sales and a two to six basis point increase in U.S. money market spreads. At the same time, deposits held with the Federal Reserve increase in response to this higher oil-price volatility, which is consistent with the model’s predictions. This evidence indicates that the widespread use of the U.S. dollar as a reserve currency acts as a channel that can propagate funding shocks from the rest of the world to the United States.

Keywords: Treasury market, repurchase agreements, market liquidity, exorbitant privilege, exchange rate peg.

JEL Classification: E43, G12, G13, G23

Suggested Citation

Alquist, Ron and Kahn, R. Jay and Dilts Stedman, Karlye and Dilts Stedman, Karlye, Foreign Reserve Management and U.S. Money Market Liquidity: A Cost of Exorbitant Privilege (September 2, 2022). Federal Reserve Bank of Kansas City Working Paper No. 22-08, Available at SSRN: https://ssrn.com/abstract=4212685 or http://dx.doi.org/10.2139/ssrn.4212685

Ron Alquist

Financial Stability Oversight Council, U.S. Treasury ( email )

1500 Pennsylvania Avenue, NW
Washington, DC 20220
United States

R. Jay Kahn

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Karlye Dilts Stedman (Contact Author)

Federal Reserve Bank of Kansas City ( email )

1 Memorial Dr.
Kansas City, MO 64198
United States

University of North Carolina (UNC) at Chapel Hill, College of Arts and Sciences, Department of Economics ( email )

Chapel Hill, NC 27599
United States

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