Historical Context
Before 1990, the Fed's biggest tool for influencing monetary policy was commercial bank's required reserves. From 1990 to 2008, it was the Federal Funds target rate. Since 2008, it's been quantitative easing and forward guidance. Going forward, I believe its going to be the Fixed Rate Full Allotment Reverse Repo Facility (FRFA RRF).

What is the FRFA RRF?
This is a facility that allows the Fed to enter into reverse repurchase agreements (repo) with market counterparties. Repo is lending somebody funds over a short period of time (usually overnight) while the borrowing entity posts collateral (usually Treasuries, Agency MBS, or Agency debt) to the lending entity. The lending entity earns return for lending (repo rate). This facility allows the Fed to use their balance sheet to do the opposite, borrow cash from the market and lending out their balance sheet (which is ~$3T) and paying the market place a fixed rate that they set.

What does it exist and why is it important?
The Fed has been able to give commercial banks a small return on assets since the crisis via interest paid on excess reserves (IOER), however there has always been a divergence between market rates (repo, Fed funds market) and the Fed Funds Target/IOER. This is a way for the Fed to more closely control short-term rates. The basic intuition is, if the Fed will pay you 25bps lend them cash, why on earth would you go to another counterparty that only pays you 20bps?

This facility is important for several reasons, it will ensure 2a-7 money market funds have a floor return to ensure their NAV is stable if/when the SEC enacts a floating NAV structure this year. Whenever the Fed does hike the target rate, it can make sure that markets rates stay in line with their target. For commercial banks, it could theoretically ensure that banks will raise their deposit rates as they hike target rates (as depositors could theoretically go other sources that will offer higher rates). For investors it's great as short-term funds will give you a higher return.

So what's the downside and/or next steps?
Right now the Fed is still in the operational testing phase, as the official testing phase ended January 29th. The key for this facility is the counterparty list. Right now only 2a-7 funds, government sponsored entities, and banks are allowed to apply for the facility. The expectation is the Fed will broaden the counterparty requirements to include asset managers and other financial entities. The effectiveness of this facility will depend on a robust counterparty list, otherwise it will only affect certain institutions and not the entire market. They've been practicing the facility in the link above while adjusting rates. The maximum allotment was raised from $3B to $5B recently and the expectation is it will be raised even higher at some point.

Why the frick is Benny so excited about this?
If the counterparty list is expanded enough, this facility could essentially floor short-term market rates. It will break the divergence between the Fed Funds target rate and short-term rates and could fend off any threat of negative nominal rates. It also gives the Fed something to do with all that balance sheet, as they weren't going to sell securities but just let them roll off. Some Fed officials have spoke about the Fed issuing bills, and this facility essentially does the same thing.

Please note that this is still in the speculative phase and this could turn out to just be another weird tool. However, if I had to bet I would absolutely bet that this is the Fed's next big monetary tool.

This post was edited on 9/17/14 at 3:52 pm