Funding Rate Spikes: How the Fed’s Balance Sheet Impacts Monetary Policy Transmission

Abstract

Sufficient reserve balances are crucial for effective monetary policy transmission by allowing arbitrage to close the gap between the central bank deposit rate and short-term funding market risk-free rates. Unexpected large spikes in U.S. dollar repo rates in recent years have posed challenges to the Fed's balance sheet normalization policy, leaving open the question of what factors determine the sufficiency of reserve balances. To address this question, I build a theoretical model that explicates the impact on short-term funding rates of strategic complementarity in intraday payment timing among banks. I show that beyond the roles of post-Global Financial Crisis liquidity and capital regulations, the sufficiency of reserves depends on a complicated interaction of (1) strategic behavior in intraday interbank payment timing, and (2) demands in wholesale funding markets. A low supply of reserves causes banks to strategically hoard reserves in intraday interbank payment timing. This strategic hoarding of reserves raises financial stability concerns for the interbank payment network and disincentivizes banks from providing liquidity to short-term funding markets, impeding monetary policy transmission. Crucially, my model reveals that as reserve balances get sufficiently low, only small or moderate changes in macroeconomic conditions are enough to have strong nonlinear or even discontinuous impacts on wholesale funding rates.