Repurchase agreements, or repos, are a tool of monetary operations used by the Fed in carrying out monetary policy. In a repo, the Fed will buy securities (Treasuries, agency securities, mortgage-backed, etc.) from authorized counterparties (i.e., primary dealers) at an agreed-upon price for an agreed-upon term. Once the term expires--and it could be anywhere from overnight to 65 days--the dealers buys back the securities with interest. You can think of a repo as a short-term loan. The Fed often uses repos to temporarily adjust the level of reserves in the banking system. 

Reverse repos are the opposite. The Fed will sell securities out of its System Open Market Account with the promise to buy them back at a higher price, the difference reflecting the interest paid. As you know, the Fed raised its policy rate, the fed funds rate, twice--in December 2015 and again last December. You can clearly see spikes in reverse repo activity around those two dates (see chart). 

Reverse Repurchase Agreements Held by the Fed

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You can see that slightly before and right around December 2015, there was a spike in reverse repo activity, and again in the recent rate hike last December. There was also a spike in October 2016 that might have been related to budgetary issues and the Treasury holding off on debt security sales that left the market temporary short. The Fed supplied the securities. 

Reverse repos and the paying of interest have added to bank deposits. This is proof that when the government pays interest, it flows to people as income and therefore bank deposits grow. Have a look (see chart). 

Deposits, All Commercial Banks

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Deposit growth had been falling steadily for four years; however, since the rate hikes it looks as if the slowdown has been stopped. In fact, as of last December, deposit growth reached the highest pace in over a year. 

Why is this important? 

Yesterday, I used that swimming pool analogy in my column. I talked about how government spending fills up the pool or can in fact drain the pool when taxation exceeds spending (running budget surpluses). I pointed out in my article that there has been a sharp slowdown in government spending in the past 10 days and that is draining the pool. 

If you understand the concept of government being a net payer of interest and if you look at what has been happening to bank deposits, you will realize that it is important for the Fed to continue these hikes because they work to offset drains that are being caused by slowdowns in government spending. 

Most people see rate hikes as negative, but they forget to understand that the non-government is a net creditor. The non-government holds the majority of that $19 trillion in government debt outstanding and there's interest paid on that. 

When the Fed raises rates, it does shift income from borrowers to creditors, but it also adds net income to the entire economy. That's helping to fill up the pool, or at least keep the water level steady. It's also adding to bank deposits. 

I guarantee you that if the Fed were to go back to cutting rates, you'd see deposit growth contract. That would be a leakage and a drain and it would not be a good thing.

At the time of publication, Mike Norman had no positions in the stocks mentioned.