Overnight Reverse Repurchase Agreement

Definition

An overnight reverse repurchase agreement (ON RRP) is a short-term secured lending transaction where the Federal Reserve (the central bank) temporarily purchases securities from eligible counterparties, such as banks and money market funds, with an agreement to sell the securities back the next business day. This tool allows the Fed to drain excess reserves from the banking system and influence short-term interest rates as part of its monetary policy operations.

5 Must Know Facts For Your Next Test

1. The overnight reverse repurchase agreement (ON RRP) is a key tool used by the Federal Reserve to implement monetary policy and influence short-term interest rates.
2. The Fed uses ON RRPs to drain excess reserves from the banking system, which helps to put upward pressure on short-term interest rates and tighten monetary policy.
3. Eligible counterparties for ON RRPs include banks, money market funds, and other financial institutions, who can earn a return on their excess cash by lending it to the Fed overnight.
4. ON RRPs are collateralized transactions, meaning the Fed receives high-quality securities as collateral from the counterparty, providing a safeguard against default.
5. The ON RRP facility is an important part of the Fed's monetary policy toolkit, alongside other tools like adjusting the federal funds rate and the discount rate.

Review Questions

• Explain how the Federal Reserve uses overnight reverse repurchase agreements (ON RRPs) to implement monetary policy.
  • The Federal Reserve utilizes ON RRPs as a tool to drain excess reserves from the banking system and influence short-term interest rates as part of its monetary policy operations. By temporarily purchasing securities from eligible counterparties, such as banks and money market funds, the Fed can reduce the amount of excess reserves in the system, which puts upward pressure on short-term interest rates. This allows the Fed to tighten monetary policy and maintain control over the availability and cost of money and credit in the economy.
• Describe the key features of an overnight reverse repurchase agreement (ON RRP) and how it differs from a traditional repurchase agreement (repo).
  • In an ON RRP, the Federal Reserve temporarily purchases securities from eligible counterparties, such as banks and money market funds, with an agreement to sell the securities back the next business day. This is a secured lending transaction, where the Fed receives high-quality securities as collateral. This differs from a traditional repo, where a party sells securities to another party with an agreement to buy them back at a higher price at a future date. The key distinction is that the Fed is the buyer in an ON RRP, while it is the seller in a traditional repo, with the goal of draining excess reserves from the banking system to influence short-term interest rates.
• Analyze the role of overnight reverse repurchase agreements (ON RRPs) within the broader context of the Federal Reserve's monetary policy toolkit and its objectives.
  • The overnight reverse repurchase agreement (ON RRP) is an important tool in the Federal Reserve's monetary policy toolkit, as it allows the central bank to drain excess reserves from the banking system and influence short-term interest rates. This is crucial for the Fed to achieve its dual mandate of promoting maximum employment and price stability. By using ON RRPs to tighten monetary policy, the Fed can put upward pressure on short-term interest rates, which helps to curb inflationary pressures and maintain economic stability. At the same time, the ON RRP facility provides a way for the Fed to provide a floor for short-term interest rates and support the smooth functioning of financial markets. Overall, the ON RRP is a flexible and effective tool that the Fed can leverage to execute its monetary policy objectives and promote the broader economic well-being of the country.

Related terms

Repurchase Agreement (Repo): A repurchase agreement (repo) is a short-term secured loan where one party sells securities to another party with an agreement to buy them back at a higher price at a future date.

Monetary Policy:

Monetary policy refers to the actions taken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to promote economic growth and stability.

Excess Reserves:

Excess reserves are funds held by banks in excess of the minimum reserve requirements set by the central bank, which can be used to increase lending and economic activity.