Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Are Using the Reverse Repo Facility
Transcript
- Lucas: So there's this tool inside the Federal Reserve's toolbox that barely anyone talked about until 2021, then everyone talked about it for three years straight, and now it's basically back to being invisible again. I'm talking about the overnight reverse repurchase agreement facility — known as the ON RRP. Luna: And you're saying that the silence right now is actually the interesting part, right? Because usage has basically collapsed. Lucas: Exactly. At its peak in mid-2024, money market funds were parking over two and a half trillion dollars in the RRP every single night. As of late June 2026, that number is hovering around 80 billion. It's essentially drained. Luna: So what happened? Did the Fed shut the door? Lucas: No, the facility is still wide open. The Fed is still offering 4.4 percent on those overnight deposits — it's the counterparties who stopped showing up. And the reason tells you something important about where all that liquidity went. Luna: Okay, let's back up for anyone who hasn't followed this closely. What exactly is the RRP facility? How is it different from the regular repo market? Lucas: Great question. The RRP is a tool the Fed created in 2013, but it really came to prominence during and after the pandemic. In a normal repo transaction, a bank or a hedge fund borrows cash and posts Treasury securities as collateral. The RRP is the exact mirror image — the Fed is the borrower, and the counterparty is lending cash to the Fed against Treasuries. The Fed pays a small interest rate, currently 4.4 percent. Luna: So money market funds basically lend to the Fed overnight. And the Fed gives them a risk-free return. That sounds like a pretty good deal for them. Lucas: It's a phenomenal deal, which is why they piled in. Between 2021 and 2024, the Treasury was issuing a ton of short-term bills, and bank reserves were plentiful. Money market funds had a choice — buy those Treasury bills at maybe 4.3 percent, or lend to the Fed at 4.4 percent with zero credit risk. They chose the Fed every time. Luna: So the RRP became like a giant parking lot for cash. But then something shifted. Lucas: Right. Starting in late 2024, the Treasury began paying down its short-term debt. It issued fewer bills, and the ones it did issue started offering yields slightly above the RRP rate. Money market funds are yield-chasers by nature. So they began pulling cash out of the RRP and buying Treasury bills directly. Luna: So the money didn't leave the system. It just moved from the Fed's parking lot into the private market. Lucas: Exactly. But here's where it gets consequential. When money leaves the RRP, it doesn't disappear — it flows into the banking system as reserves. Because the money market fund buys a Treasury bill from a primary dealer, the dealer's bank gets a deposit. That increases aggregate bank reserves. Luna: And we're in the middle of quantitative tightening, right? The Fed is still letting Treasuries and mortgage-backed securities roll off its balance sheet. So those two forces are working in opposite directions. Lucas: They are, and that's the fascinating tension. QT is draining reserves by about 60 billion a month. But the RRP drain has been adding reserves back at a much faster clip. For most of 2025, the net effect was that reserves actually stayed fairly stable, even as the balance sheet shrank. Luna: So the RRP essentially acted as a shock absorber for QT. It gave the Fed room to keep shrinking the balance sheet without starving the banking system of reserves. Lucas: Precisely. And now that the RRP is almost empty, that buffer is gone. Every dollar of QT from here on out will be a dollar of reserves drained. So the Fed has to watch very, very carefully for signs of reserve scarcity. Luna: What would reserve scarcity look like in practice? I mean, we saw what happened in September 2019 when repo rates spiked to 10 percent. Lucas: That's exactly the nightmare scenario. In September 2019, reserves had fallen too low because of a combination of QT and corporate tax payments. Banks couldn't intermediate Treasury cashflows, and overnight lending rates exploded. The Fed had to intervene with emergency repo operations. Luna: And the RRP facility was actually created partly as a response to that crisis, right? To give the Fed a permanent tool to control short-term rates. Lucas: That's right. The RRP puts a floor under money market rates. If rates ever fall below the RRP rate, money market funds can just lend to the Fed instead, which pushes rates back up. So even with usage near zero, the facility itself provides a backstop. Luna: But if it's not being used, it's more of a safety net than an active tool. Lucas: Exactly. And the question now is whether the Fed will keep it in place or shrink it. There are some Fed officials who argue that the RRP distorts the market by creating an artificial floor. Others say it's essential insurance against another repo blow-up. Luna: What do you think? Should they keep it? Lucas: I'd lean yes, because the cost is minimal — the facility pays interest only when it's used, and right now it's hardly costing anything. But more importantly, we've learned that the plumbing of the financial system can break in unexpected ways. Having a known, tested backstop is cheap insurance. Luna: You know, this kind of deep dive into a specific tool is exactly why this show is useful. And the fact that we can do it without any ads or sponsors is something I'm grateful for. Lucas: I'm with you. If today was actually useful to you, the way these stay ad-free is listener support. That's buy me a coffee dot com slash fexingo. All lowercase. Luna: We keep it simple, no pressure. Just if you want to help keep the economics nerdery going. Lucas: Back to the plumbing. So we've got this nearly empty RRP facility, and the Fed is still shrinking the balance sheet. The next milestone to watch is when reserves get low enough that the Fed has to stop QT. We don't know where that level is — the Fed's own estimates have been wrong before. Luna: But there are signals, right? Like the fed funds rate trading above the interest on reserves, or repo rates showing volatility. Lucas: Those are the classic tells. Right now, fed funds is stable right in the middle of the target range, and repo rates have been calm. But the market is already pricing in a QT end by late 2026 or early 2027. The RRP drain has accelerated the timeline. Luna: So in a way, the RRP did its job. It absorbed excess cash during the pandemic, and then it released that cash back into the system during QT, smoothing the transition. That's actually pretty elegant. Lucas: It is. And I think it will be studied as one of the more successful innovations in monetary policy implementation. The Fed invented a tool, tested it during a crisis, and used it to manage the balance sheet normalization process without causing a market meltdown. Luna: But there's still an open question about what happens if we ever need it again. If the Treasury issues a ton of short-term debt again, will the RRP refill? Lucas: It could. If bill supply surges and the RRP rate is above Treasury bill yields, money market funds will flood back in. So the facility is kind of like a bathtub — it fills and drains depending on relative yields. The Fed just has to keep the plug in place. Luna: So the real takeaway for me is that the RRP facility, even when it's empty, matters. It's a signal of where we are in the liquidity cycle. Lucas: Exactly. And watching it drain has given us a real-time map of how money moves through the system. It's one of those boring technical topics that actually explains a huge amount about the current state of markets. Luna: Alright, next time someone asks you why the Fed is still shrinking its balance sheet, you can point to the RRP and say, 'Because we still have a buffer — but it's almost gone.' Lucas: And that's the kind of thing that makes you sound like you really know what you're talking about at a dinner party. Or at least at a very specific economics-themed dinner party. Luna: I'll take it. Thanks, Lucas. Lucas: Thanks, Luna. That's it for this episode of Monetary Policy Explained.