Recent movements in short-term loan markets are a timely reminder of a forgotten truth: The Federal Reserve is not the master of credit conditions. It can influence interest rates, but it cannot dictate them. Interest rates ultimately reflect supply and demand conditions in the broader financial system. When those conditions shift, the Fed’s administered rates give way to market realities.
That’s precisely what we’re seeing in the repo market now.
In an overnight repurchase agreement (or a “repo” in financial industry shorthand), a (borrowing) financial institution sells Treasuries to—and, hence, receives dollars from—another (lending) financial institution today and promises to buy them back tomorrow at a slightly higher price. The repo is economically equivalent to a collateralized loan, with the interest rate—or, repo rate—implied by the mark-up in price. According to a recent Reuters article, market repo rates have ranged between 4.05 and 4.25 percent this month.
The Fed also participates in the repo market, selling Treasuries today and buying them back tomorrow. It does so in order to create a lower bound for the federal funds rate—that is, to prevent the federal funds rate from falling too far below the interest rate the Fed pays on reserves. But market repo rates are currently above the Fed’s overnight repo rate (3.75 percent), the interest rate it pays on reserves (3.90 percent), and its federal funds rate target range (3.75 – 4.0 percent). Why are market participants agreeing to overnight rates that are greater than the Fed’s target range?
This is no mere technical curiosity. It speaks to the inherent limits of discretionary monetary policy. The repo market is revealing something central bankers don’t always like to admit: The Fed cannot micromanage short-term capital markets.
Consider what’s driving the rate divergence. Bank reserves have declined significantly this year as the Treasury ramped up short-term borrowing to finance federal spending. When the government issues a torrent of new bills, interested buyers must come up with cash. That cash often comes from the banking system, draining reserves and tightening liquidity. No central bank edict can repeal this balance sheet constraint.
We have a three-way contest of goals: The Fed wants short-term credit conditions to reflect its policy stance. The Treasury wants to raise funds at the lowest possible cost. The banking system wants to preserve balance sheet flexibility. When these objectives collide, interest rates move. They may adjust in ways the Fed prefers—or, they may not. Even with all its powers, the Fed is only one among many actors, and its toolkit is constrained by economic reality.
The problem is that Fed policymakers routinely overestimate their capacity to steer markets whose internal dynamics are beyond their control. Overconfidence leads to poor expectations management—both inside and outside the central bank. Commentators talk as though interest rates were policy variables, not market prices. Politicians assume the Fed can deliver any desired macroeconomic outcome with enough determination. Even some monetary economists slip into this misguided way of thinking. We must not forget: the Fed’s administered rates only work when they are consistent with actual credit conditions.
The Fed can’t lower market rates by fiat. It can offer premium terms, but it can’t compel counterparties to trade with it. When reserves are tight, financial institutions flush with reserves will be able to lend some to financial institutions short on reserves at a rate greater than the Fed is paying. Ultimately, there is nothing magical about the Fed’s tools. They work only to the extent they comport with market fundamentals.
A free society needs its public institutions to recognize their limits. Sound monetary policy requires humility before all. The central bank’s proper role is maintaining the value of money, not fiddling with the price of credit. The structure of interest rates—those prices that coordinate the allocation of capital—is a job for markets, not bureaucracies.
This is why rule-based monetary frameworks are so important. A central bank operating with a narrow mandate (i.e., price stability) does not pretend it can fine-tune every fluctuation in credit conditions. It does not confuse its administered rates for true market prices. And it does not attempt to subordinate trends in the repo market to its technocratic will. Rules force policymakers to accept what should be obvious: markets set prices.
Ongoing repo dynamics are a lesson, not a crisis. They reveal the complex interaction between fiscal policy, balance sheet constraints, and liquidity preferences. But they also reveal a deeper principle. The Fed proposes an overnight rate; the market dispenses real resources. When the two differ, the market has the last word.
Our monetary institutions would be stronger if they embraced this reality rather than resisted it. Stabilizing the value of money is the Fed’s proper task. Interest, as the price of credit, belongs to markets. When policymakers forget that distinction, the resulting confusion harms the very economic coordination that free markets excel at providing.
