Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why the Fed Uses Standing Repo Facilities
Transcript
- Lucas: So June 2026, and the Fed's balance sheet is still slowly shrinking — around seven trillion dollars today. But there is a piece of plumbing most people have never heard of that's been quietly keeping the whole machine from seizing up. It's called the Standing Repo Facility, or SRF. And its sibling, the Standing Overnight Reverse Repo Facility — the ON RRP. Luna: I hear 'repo' and my brain glazes over. But these two facilities — they're basically emergency exits for money markets, right? Lucas: Exactly. Think of them as the Fed's way of putting a floor and a ceiling on short-term interest rates without having to intervene every single day. The ON RRP sets a soft floor, the SRF sets a ceiling. Together they create what's called a 'floor system' for the fed funds rate. Luna: And that replaced the old corridor system we used to have before 2008, where the Fed kept rates within a range using the discount window and interest on reserves. Lucas: Right. But here's why the SRF matters right now. In September 2019, repo rates spiked to nearly ten percent overnight. That was a massive plumbing failure. The Fed had to step in with emergency repos. The SRF was built so that never has to happen again. Luna: So it's like a permanent fire extinguisher instead of calling the fire department after the house is already burning. Lucas: That's exactly the analogy. And look — this show doesn't have ads, which means we can talk about this stuff without interruption. We're listener-funded, and if walking through the economy with us has made something click, a few of our listeners chip in monthly over at buy me a coffee dot com slash fexingo. It's what keeps us ad-free and focused on explaining the plumbing. Luna: Yeah, it genuinely helps. And it means we can spend a whole episode on repo facilities without anyone telling us to buy a mattress. Lucas: So back to the SRF. It was launched in July 2021. Any eligible bank or primary dealer can borrow cash overnight from the Fed by posting Treasury or agency MFP securities as collateral. The rate is set a little above the general collateral repo rate — currently around the top of the fed funds range. Luna: So it's a backstop. If repo rates start to spike, institutions can go to the Fed instead of paying crazy rates in the open market. Lucas: Correct. And the ON RRP works in reverse. Eligible counterparties — mostly money market funds and government-sponsored enterprises — can park cash at the Fed overnight and earn a rate slightly below the fed funds target. That puts a floor on rates because if money market rates fall below that, they'd rather lend to the Fed. Luna: So the ON RRP keeps rates from falling too low, and the SRF keeps them from rising too high. A nice little corridor — wait, but you said 'floor system' not 'corridor.' What's the difference? Lucas: In a true corridor system, the central bank sets a lending rate and a deposit rate, and market rates float between them. The Fed sort of has that with the discount window and interest on reserves. But the floor system means the Fed actively supplies or absorbs reserves to keep the fed funds rate near the target. These standing facilities just make sure it doesn't drift too far. Luna: So they're guardrails, not the road itself. Lucas: Exactly. And here's where it gets specific. In 2023 and 2024, the ON RRP balance was huge — over two trillion dollars at its peak. Money market funds were parking cash there because it was a safe place to earn interest while the Fed was hiking rates. But as the Fed started cutting in late 2024, the ON RRP balance fell sharply. Luna: Because the rate the Fed pays on ON RRP drops with the fed funds rate, so money market funds look for better returns elsewhere. Lucas: Right. By early 2026, the ON RRP balance is down to around three hundred billion. That's actually a healthy level — it means money is flowing back into the private market. But the SRF has barely been used. In fact, since it started, there's only been a handful of days where anyone tapped it. Luna: So is it a solution in search of a problem? I mean, if nobody uses it, why have it? Lucas: That's the billion-dollar question. The Fed argues it's insurance. You don't use your fire extinguisher every day, but you're glad it's there when you need it. The SRF acts as a credible backstop — just its existence prevents panic because everyone knows they can borrow at a known rate if things go wrong. Luna: Like a nuclear deterrent for repo markets. Lucas: Exactly. But there is criticism. Some economists say the SRF is too generous — that it effectively subsidizes banks and dealers by giving them a cheap source of liquidity in a crisis, while the ON RRP is too attractive and drains reserves from the banking system unnecessarily. Luna: So there's a tension between having a safety valve and creating moral hazard. Lucas: Right. And there's also the issue of counterparty access. The SRF is only available to primary dealers and banks. That means hedge funds and other non-bank financial institutions — the ones that actually caused the 2019 repo spike — can't use it directly. They have to go through a bank, which adds friction. Luna: So if we get another Lehman-style event at a big hedge fund, the SRF may not help them directly. Lucas: Not unless they have a bank relationship. And that's a real vulnerability. The Fed has expanded the list of eligible counterparties for the ON RRP — money market funds, GSEs — but the SRF remains restricted. That's partly by design, because the Fed wants to limit its credit risk. Luna: But it means the safety net has holes. Lucas: It does. And that's an ongoing debate in central banking circles. Some argue the Fed should open the SRF to a broader set of participants, perhaps with higher haircuts or collateral requirements. Others say that would just encourage risk-taking. Luna: So where does this leave us in mid-2026? The Fed is still shrinking its balance sheet — quantitative tightening is ongoing but at a slow pace. Do these facilities make QT easier? Lucas: They do. Because as reserves drain from the banking system, there's a risk that repo markets could get stressed again. The SRF and ON RRP act as shock absorbers. In fact, in the Fed's June 2026 Summary of Economic Projections, Chair Powell noted that the standing facilities are functioning as intended, providing a floor and ceiling that keep short-term rates within the target range. Luna: So they're not just theoretical. They're actively shaping how we think about the endgame of QT. Lucas: Exactly. When reserves get scarce, banks become more reluctant to lend in the repo market. That pushes rates up. The SRF caps that rise. And if rates fall too low, the ON RRP absorbs excess cash. It's a self-correcting mechanism. Luna: One thing I've always wondered — with the ON RRP paying a rate below the fed funds target, why do money market funds use it at all? Couldn't they just lend in the private market for a slightly higher rate? Lucas: In theory, yes. But in practice, the ON RRP is a perfectly safe, liquid, and scalable option. Private repo might offer a few basis points more, but it comes with counterparty risk and operational complexity. For large money market funds managing hundreds of billions, the ON RRP is a convenient parking spot. Luna: So it's like the 'default option' — not necessarily the best rate, but the safest and easiest. Lucas: Precisely. And that's actually a feature, not a bug. The Fed wants the ON RRP to be attractive enough to set a floor, but not so attractive that it sucks all liquidity out of the private market. That's a delicate balance. Luna: And the SRF, by contrast, is priced to be a backstop — you'd only use it if the private market is really broken. Lucas: Right. The SRF rate is set at the top of the fed funds range, so it's deliberately unattractive under normal conditions. But if repo rates spike, it becomes the best deal in town. Luna: Let's talk about the actual mechanics for a second. When a bank uses the SRF, what exactly happens? They post collateral, get cash overnight, and pay interest. But is the Fed creating new reserves when it does that? Lucas: Great question. Yes — when the Fed lends through the SRF, it creates reserves. That's the transmission mechanism. It expands the balance sheet temporarily. That's why the SRF is a standing facility — it automatically provides liquidity when needed, rather than requiring ad hoc open market operations. Luna: So in a crisis, the Fed's balance sheet would automatically expand through the SRF, without any committee vote or press conference. Lucas: Exactly. That's the beauty of it. It's rules-based. No discretion needed. The facility is always open, the terms are known in advance, and counterparties can decide to use it when they need it. That's very different from the 2008 playbook, where the Fed had to invent new facilities on the fly. Luna: So it's a lesson learned from the financial crisis and the 2019 repo blow-up. Lucas: Completely. And I think that's worth emphasizing. Central banking is often about learning from past mistakes and building better infrastructure. The SRF and ON RRP are exactly that — infrastructure for the modern financial system. Luna: So if I'm a listener trying to explain this to a friend, what's the one-sentence takeaway? Lucas: The Fed now has permanent, automatic backstop facilities that keep short-term interest rates from veering too far from target, even during extreme stress — and that makes the whole financial system more resilient. Luna: And they're mostly invisible, until they're not. Lucas: Right. Like the best infrastructure. You only notice it when it fails. The hope is these facilities make failure a lot less likely. Luna: Alright, I feel like I finally get repo. Thanks, Lucas. Lucas: Same here, Luna. Until next time.