The Capacity Is Not Fixed

This chapter applies the repo-capacity model to the factors that change who can lend, who must borrow, and which official institution is responding. The focus is practical but bounded: readers should be able to tell whether a pressure comes from MMF portfolio incentives, Treasury-bill supply, dealer intermediation, an official repo backstop, or long-end Treasury liquidity—and avoid inferring a rate or reserve effect that the evidence does not establish.

The September 2019 episode showed that capacity depends on the state of the system, not on a reserve total alone. That state is shaped by incentives and rules as well as quantities. A policy rate can change where investors keep cash. Treasury-bill supply can change what MMFs hold instead of lending in repo. Regulation can limit a dealer’s willingness to intermediate. A standing repo facility can provide an official source of funding when private capacity is under pressure. Treasury can also use buybacks to support liquidity in a particular part of the coupon market. These interventions are related because they respond to market functioning, but they do not solve the same problem.

Incentives change who can lend

The policy-rate environment affects repo capacity through money market funds. The Federal Reserve note draws on earlier research to explain that increases in the policy rate pass through more fully to MMF yields than to bank deposit rates. When that happens, MMF shares can become relatively more attractive than bank deposits, encouraging money to move from banks to MMFs. Higher MMF assets under management, or AUM, expand the potential pool of cash that can be lent in repo.

This is a supply response mediated by investor choice. The policy rate does not directly pour a fixed amount of cash into repo. It changes the relative return on different places to hold cash, which can change the size of the MMF sector and therefore its lending capacity. The speed and size of the response are not supplied as a new quantitative estimate in the note. Nor does a larger AUM guarantee that every additional dollar will be offered in repo. A fund can hold Treasury bills or alter maturities instead.

Expectations about future policy rates matter for the same reason. The note says MMFs tend to adjust weighted-average maturities and bill portfolios in response to their expectations. If a fund expects rates to change, it may alter the maturity of its assets or the balance between bills and repo. Current policy rates and expected future rates can therefore affect not only how much money reaches MMFs, but also how much of that money is available to the repo market at the moment a dealer needs it.

This gives the repo market an incentive channel that is easy to miss in a reserve-only model. Two periods can have similar aggregate liquidity and different repo capacity if MMFs have different reasons to hold bills, lend overnight, or preserve flexibility. A change in the policy rate can improve the potential supply of repo cash by attracting assets into MMFs, while a change in expectations can make those funds more cautious about maturity or allocation. The direction of the aggregate effect must therefore be read together with portfolio composition rather than inferred from the rate level alone.

Treasury-bill supply is the clearest example of portfolio competition. Bills are a primary investment option for MMFs and a close substitute for repo lending. When more bills are available to the private sector, MMFs may allocate more cash to bills and have less available to lend against Treasury collateral. That can raise repo rates even without a corresponding increase in dealer coupon inventory.