Repo (Repurchase Agreement) – Injecting Liquidity
A repo is when the Fed buys U.S. Treasury securities or other government-backed securities from banks with an agreement to sell them back at a slightly higher price in the future (often overnight or within a short period).
How It Works:
- The Fed provides cash to banks and financial institutions by buying securities.
- Banks receive short-term liquidity, which they can use to lend or invest.
- The banks agree to repurchase the securities at a pre-determined price on a set date.
Why the Fed Uses Repos:
- To increase liquidity in the banking system.
- Helps keep short-term interest rates low and stable.
- Ensures banks have enough cash to meet short-term funding needs.
📌 Example:
If there’s a liquidity crunch (e.g., financial crisis), the Fed can inject cash into the system through repos, ensuring banks can continue lending.
Reverse Repo (Reverse Repurchase Agreement) – Absorbing Liquidity
A reverse repo is when the Fed sells securities to banks and financial institutions with an agreement to buy them back later. This withdraws liquidity from the system.
How It Works:
- The Fed sells U.S. Treasuries to banks, money market funds, or financial institutions.
- The banks pay cash to the Fed, reducing the amount of money in circulation.
- The Fed agrees to buy back the securities at a slightly higher price later.
Why the Fed Uses Reverse Repos:
- To drain excess liquidity from the banking system.
- Helps control inflation by reducing the amount of money available for lending.
- Prevents short-term interest rates from falling too low.
📌 Example:
If inflation is rising due to too much money in the system, the Fed can pull cash out of circulation by conducting reverse repos.
Fed’s Role in Repo & Reverse Repo Markets
- Monetary Policy Control
- Repos → Used when the Fed wants to lower short-term interest rates and boost liquidity.
- Reverse Repos → Used when the Fed wants to raise short-term interest rates and drain liquidity.
- Federal Reserve’s Overnight Reverse Repo Facility (ON RRP)
- The Fed offers money market funds, banks, and government-sponsored enterprises a safe place to park excess cash overnight.
- Institutions lend money to the Fed and receive Treasuries as collateral.
- Helps set a floor under short-term interest rates.
Real-World Example: 2021-2023 Reverse Repo Surge
- During 2021-2023, the Fed conducted large-scale reverse repo operations to absorb excess liquidity from COVID-19 stimulus measures.
- By mid-2023, money market funds parked over $2 trillion daily in the Fed’s reverse repo facility, reducing inflationary pressures.
- This helped keep short-term interest rates above 5% as the Fed fought inflation.
Summary Table
| Feature | Repo (Repurchase Agreement) | Reverse Repo (Reverse Repurchase Agreement) |
|---|---|---|
| Who Buys Securities? | The Fed (injects cash) | Banks/institutions (drains cash) |
| Who Sells Securities? | Banks/institutions (receive cash) | The Fed (absorbs cash) |
| Purpose | Increases liquidity, lowers rates | Reduces liquidity, raises rates |
| Impact on Inflation | Can increase inflation | Helps control inflation |
| Fed’s Role | Lends cash, buys securities | Borrows cash, sells securities |
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