Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Reverse Repo Facility
Transcript
- Lucas: If you follow central banking even casually, you've probably heard the phrase 'reverse repo facility' thrown around — especially back in 2021 and 2022, when the numbers got enormous. But it's actually a pretty elegant tool, and right now, its collapse is telling us something important about the plumbing of the U.S. financial system. Luna: Yeah, I remember seeing headlines about the facility hitting two trillion dollars in daily usage. But then by last year, it was basically zero. What happened? Lucas: Right. Let's start with what the facility actually is. The Fed's overnight reverse repo facility — they call it the ONRRP — is essentially a place where money market funds and other eligible institutions can park cash overnight with the Fed, earning a small interest rate. The rate is set just below the Fed's main policy rate, the interest on reserve balances. Luna: So it's like a parking lot for cash. Why would a money market fund use it instead of lending in the private repo market? Lucas: That's the key question. Under normal conditions, private repo rates trade slightly below the ONRRP rate, so funds have no incentive to use the facility — they'd rather earn a bit more by lending to banks or hedge funds overnight. But during periods of extreme liquidity abundance, like after the Fed's massive bond purchases in 2020 and 2021, there was so much cash in the system that private repo rates fell well below the ONRRP rate. Luna: Because there was more cash than collateral to lend against? Lucas: Exactly. The supply of cash exceeded the supply of high-quality collateral like Treasury bills. So money market funds couldn't find enough private repo counterparties, and they flooded into the Fed's facility instead, because it offered a better rate than leaving cash idle. Usage peaked at over two trillion dollars in December 2021. Luna: That's a staggering number. And then the Fed started quantitative tightening in mid-2022 — shrinking its balance sheet. That should have drained reserves from the system. But the reverse repo facility actually stayed elevated for quite a while. Lucas: That was the puzzle. When the Fed lets securities roll off its balance sheet, it reduces reserves in the banking system. Normally, you'd expect less cash sloshing around, so reverse repo usage should fall. But it didn't — not at first. The reason is that the Treasury also changed its cash management. In early 2022, the Treasury was drawing down its general account at the Fed to keep paying bills while the debt ceiling was unresolved. Luna: So the Treasury was injecting cash into the system even as the Fed was draining it? Lucas: Exactly. The Treasury's cash balance fell from over one point six trillion dollars in mid-2021 to around four hundred billion by mid-2022. That cash flowed into bank reserves and then into money market funds, which then parked it at the reverse repo facility. So the ONRRP acted as a shock absorber — it soaked up the excess liquidity that would otherwise have pushed short-term rates too low. Luna: But then it collapsed. By mid-2024, ONRRP usage was under one hundred billion. What changed? Lucas: Two things. First, the Treasury started rebuilding its cash balance again after the debt ceiling was raised. That pulled reserves out of the system. Second, quantitative tightening continued, reducing reserves further. At some point, the banking system went from having too much liquidity to having just enough — and money market funds started finding better returns in private repo again. Luna: So the ONRRP acted like a canary in the coal mine. When it's high, reserves are abundant. When it falls, we're approaching a point where reserves might become scarce. Lucas: That's exactly the framework the Fed uses. In fact, some Fed officials have pointed to the decline in ONRRP usage as a sign that quantitative tightening can continue without causing a repeat of September 2019, when repo rates spiked to ten percent because banks had too few reserves. Luna: But wait — if the ONRRP goes to zero and QT continues, aren't we right back in that danger zone? Lucas: That's the debate now. As of July 2026, ONRRP usage is essentially zero — it's been below twenty billion for months. The Fed has also slowed the pace of quantitative tightening, but the balance sheet is still shrinking. Some analysts estimate we're within a few hundred billion dollars of the minimum comfortable level of reserves. Luna: And the problem is that we don't know exactly where that minimum is. It's like driving a car with no fuel gauge. Lucas: Right. The Fed has been studying this for years, and they have models that estimate reserve demand, but the actual threshold is only observable when you hit it. That's why they've been so cautious — they've already cut the monthly cap on Treasury roll-offs from sixty billion to twenty-five billion. Luna: So the reverse repo facility isn't just a technical footnote. It's a real-time indicator of whether the financial system has enough liquidity. Lucas: It's one of the best. And it's also a reminder that central bank tools interact in ways that aren't always obvious. The ONRRP was created after 2013 as a backstop for money market rates, but it ended up playing a starring role in the post-pandemic normalization. It's a great case study in how a tool designed for one purpose can become essential for another. Luna: And speaking of things that are essential but easy to overlook — a lot of listeners have told us that this kind of deep dive into financial plumbing is exactly why they tune in. If you've gotten value from walking through the economy with us, a couple of dollars a month is genuinely what keeps these episodes ad-free and independent. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it really does make a difference. Even small contributions add up and let us keep spending time on topics like this instead of chasing sponsors. So thank you to everyone who's already supported the show. Luna: Absolutely. And to bring it back to the reverse repo facility — one interesting recent development is that some market participants are now watching the ONRRP not just for aggregate signals, but for distributional effects. Which funds are using it, and why? Lucas: Great point. Government-only money market funds — the ones that invest solely in Treasury and agency securities — tend to be the biggest users. When ONRRP usage was high, it was largely these funds parking cash. But as usage has fallen, we've seen some funds exit the facility entirely, which suggests they're finding better yields in the private market. That's a healthy sign. Luna: But what if the private repo market gets disrupted? Could we see a sudden spike back into the facility? Lucas: Hypothetically, yes. If a counterparty fails or collateral becomes scarce, funds could flee to the Fed's facility. That's exactly what the ONRRP is designed for — as a backstop. But the more concerning scenario is if ONRRP usage stays at zero and QT continues, and then we hit the reserve scarcity point. That would look more like a squeeze in repo rates, not a flood into the facility. Luna: So the ONRRP is a useful indicator, but it's not the only one. The Fed also watches the federal funds rate, the IOER rate, and the spread between them to gauge reserve scarcity. Lucas: Exactly. They have a whole dashboard. But the ONRRP is unique because it directly measures the amount of cash that can't find a home in the private market. It rose to record levels and then vanished. And right now, its disappearance is the most telling signal that the post-pandemic era of super-abundant reserves is over. Luna: And possibly that we're approaching a new phase — one where the Fed has to think more carefully about where the balance sheet ends up. Lucas: Right. The reverse repo facility won't always be in the headlines, but it will always be there, waiting in the background. A quiet piece of plumbing that tells you a lot about the state of the system.