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Last week the head of the Dallas Federal Reserve gave a speech about something recondite and easy to ignore in an era where the US central bank’s independence is under assault — but still vitally important.
When we say that a central bank raises or lowers “interest rates”, it actually elides what is actually happening, just to keep things simple. Different monetary institutions target different rates and with different tools, but in the US it actually means the federal funds market.
The fed funds market is where US banks lend or borrow short-term reserves to the level dictated by regulations, and the Federal Reserve has long sought to control the price of money and regulate the temperature of the US economy by dictating a target for the rate they pay for fed funds. Historically it did that tweaking reserve requirements, or by adding or sucking out money that was sloshing around in the market.
However, as Alphaville has written many times before, all the quantitative easing programmes of the past two decades have flooded the banking system with “excess” reserves. That forced the Fed to invent new tools to set interest rates and rendered the fed funds market an emasculated joke — even though the fed funds target has remained.
Finally, this perverse situation is being acknowledged by policymakers. On Thursday evening, Lorie Logan, the head of the Dallas Fed, argued that “the fed funds target is showing its age” and suggested that it should be replaced with something better.
In the mid-1990s, the fed funds rate was well suited as a guide to money market conditions. Bank reserves at the time didn’t pay interest. With market rates typically hundreds of basis points above zero, any bank that had excess reserves was highly motivated to lend them out to peers that were short of required reserves. These incentives created a vibrant unsecured interbank market where the interest rate closely reflected banks’ marginal cost of funds.
That is not the world we live in anymore.
Yup.
It’s easy to forget that the Federal Reserve didn’t always have a fed funds rate target. Back in the 1980s, the Fed actually targeted the level of borrowed reserves, and the fed funds rate was just an indicator to watch. In the 1970s it targeted broad money measures, and before that it mostly used reserve requirements. So, while radical, the Fed switching targets is far from unprecedented.
Logan also stressed that fed funds “remains a viable target”, at least for now. Thanks to the central bank’s newer tools — such as interest on reserve balances — it has been easily able to ease or tighten monetary policy whenever it wished. Changes to the fed funds target have flowed swiftly and cleanly through to the US interest rate complex as a whole.
However, the connection between fed funds and broader monetary conditions is “fragile”, she warned. It’s a very concentrated market dominated by a under a dozen weird US mortgage co-operatives and the US branches of a few foreign banks. Just because it has worked until now doesn’t mean it will continue to work, as long as fed funds remains a shadow of its former self.
So what does Logan think should replace the fed funds target? She thinks there are three broad candidates:
— An “administered” rate that the Fed itself controls, such as interest rates on reserves that banks have to hold at the central bank, or its Standing Repo Facility.
— A combination of market rates, such as the Secured Overnight Financing Rate and a variety of repo rates.
— A single, new market rate, like SOFR or the tri-party general collateral rate.
Logan thinks that an administered rate is a bad idea, simply because it will always be what the Fed wants it to be. It’s therefore better to have market-set rate that the central bank can try to influence with its tools. She’s also sceptical of a “constellation of market rates” because of the messiness that this would entail.
SOFR might be the obvious candidate if you had to just choose one rate to rule them all — given that it is now the dominant replacement for Libor — but Logan favours a different target. Alphaville’s emphasis below:
Participants in dollar funding markets have widely adopted SOFR as a reference rate. It covers north of $2.5 trillion a day in overnight Treasury repos. But SOFR isn’t currently a clean gauge of funding costs.
SOFR combines two main market segments: tri-party repos that take place primarily between cash investors and large dealers, and centrally cleared repos that take place primarily between large dealers and smaller ones or leveraged investors. Large dealers have some market power in intermediating between the segments, so rates in the centrally cleared segment can partly reflect market power rather than the cost of funds.
The tri-party general collateral rate (TGCR) is cleaner, and I think it would currently offer the best target. It incorporates more than $1 trillion a day in risk-free transactions that represent a marginal cost of funds and marginal return on investment for a large number of participants. It is calculated with a robust methodology. It transmits well across money markets. And the Fed’s existing tools already provide effective control of TGCR.
Let me be clear that by control, I don’t mean pinpoint control to the basis point. In an ample reserves regime, money market rates should average close to interest on reserves, but there can be some fluctuations around that average. It would be perfectly fine, in my view, for TGCR to move up and down from day to day, much as it has for many years. After all, the target range is 25 basis points wide. A tolerance for modest volatility would allow us to maintain rate control with our current simple and efficient tools, without large, frequent or complex operations.
A reminder that Logan was in charge of the Fed’s balance sheet at the NY Fed before she moved to Dallas, so she knows her stuff. If you want more, here is an accompanying paper co-authored by Logan and Dallas Fed economist Sam Schulhofer-Wohl that goes in more depth than her speech.
You could argue that targeting the TGCR wouldn’t necessarily be a radical step, given that the Fed already uses its permanent repo and reverse repo facilities to set the ceiling and floor for the fed funds rate target. This would just be embracing and formalising something that is already a fact. But the scrapping of a fed funds target — for the first time since 1996 — would still be a big deal.
Logan’s speech doesn’t seem to have caused a stir which is disappointing but understandable given all the other brouhaha surrounding the Fed nowadays.
It’s also unclear whether the proposal is a goer. The Richmond Fed president Tom Barkin told Bloomberg on Friday that he thought it was “very interesting and thoughtful”, but Logan going public might have been triggered by disappointment that the subject isn’t going to be included in the Fed’s latest review of its own framework.
As Bank of America’s Mark Cabana wrote:
There is not a clear catalyst for Logan’s speech timing. Our best guess: Logan may have been frustrated by lack of policy target inclusion in framework review. With FF [fed funds] out of framework review, Logan needed to advocate herself. She prefers quick TGCR transition.
We expect the Fed to move from FF to a repo target but the process may be slow. We guess 1Y or so before an official transition. Long time due to focus on topic very limited from other Fed officials. Logan has big hill to climb vs Fed institutional inertia.
Quite. But this at least gets the ball rolling.