The Daily Technical #123: What is working capital?

How to answer "If the Fed wants to increase rates, what can it do?"

February 28, 2025

Good morning. Welcome to the 123rd edition of The Daily Technical.

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OVERVIEW OF YESTERDAY’S QUESTION
If the Fed wants to increase rates, what can it do?

If the Fed wants to raise rates, it can sell treasury bills in the open market. The Fed lends cash overnight to a select group of banks (“primary dealers”) while taking treasuries as collateral at the repo rate. These primary dealers will then disseminate this cash throughout the financial system; thus, the fed funds rate increases.

If the Fed wants higher rates, it can also do a reverse repo (“RRP”), in which the Fed borrows money from primary dealers. This would tighten the credit markets, and the fed funds rate would increase.

Common Mistakes

  1. Confusing selling treasury bills with borrowing them. When the Fed sells treasuries, it pulls money out of circulation, raising rates.

  2. Overlooking the role of repo transactions in adjusting rates. The Fed uses repos to manage short-term interest rates by lending cash and accepting treasuries as collateral.

  3. Confusion between repos and reverse repos. In a repo, the Fed lends money; in a reverse repo, it borrows.

TL;DR

  • To raise rates, the Fed sells treasury bills, lending overnight with treasuries as collateral.

  • Primary dealers spread the cash, causing the fed funds rate to rise.

  • Reverse repo (RRP): Fed borrows from primary dealers, tightening credit markets.

  • Both actions increase the fed funds rate by reducing available credit.

TODAY’S QUESTION
What is working capital?

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