“The FOMC should modernize the target rate”: Dallas Fed president Lorie Logan.
By Wolf Richter for WOLF STREET.
The Fed has for decades used the “federal funds rate” as the headline target for its key policy rate. The “effective federal funds rate” (EFFR) is a market rate observed in the federal funds market, where banks lend to each other overnight without collateral (unsecured). When unsecured interbank lending was still a huge activity, the EFFR measured the marginal cost of money for a wide range of financial institutions, and it mattered.
But during the Financial Crisis, unsecured interbank lending contributed to contagion, as banks suddenly stopped lending to each other, and that daily funding mechanism banks had relied on for decades suddenly dried up, and banks had trouble funding their daily short-term needs. The Fed stepped in with QE and the federal government with a bailout and new regulations.
And what resulted from QE and from changes in capital and liquidity regulations was that banks, now loaded up with reserves from QE, stopped using unsecured interbank lending, and activity in that market collapsed to near nothing and is now largely limited to a bizarre arbitrage trade between the Federal Home Loan Banks (FHLBs) and foreign banks, that we’ll get to in a moment.
In October, the average daily activity in the federal funds market was just $89 billion a day, compared to the $5-trillion-a day activity in the overall repo market, the $3-trillion-a-day portion of the repo market tracked by Secured Overnight Financing Rate (SOFR), and the $1-trillion-a-day portion of the repo market tracked by Tri-Party General Collateral Rate (TGCR).
So the federal funds market and the federal funds rate – and thereby the Fed’s key measure for its rate target – have become essentially inconsequential for the market that actually matters, the repo market.
With its rate cut on Wednesday, the Fed lowered its target for the federal funds rate to a range between 3.75% and 4.0%, which everyone cites, but which is essentially irrelevant.
The Fed now also has four “administered rates” that the Fed sets at its policy meeting. And they do matter. These are not market rates:
- Interest rate the Fed pays banks on reserves (3.9%);
- Interest rate the Fed pays on Overnight Reverse Repos or ON RRPs (3.75%);
- Interest rate the Fed charges on overnight repos at its Standing Repo Facility or SRF (4.0%).
- Interest the Fed charges banks to borrow at the Discount Window (4.0%).
The first two are “floor rates” and latter two are “ceiling rates.” These administered rates are what functionally transmit the Fed’s policy rates to the overnight lending market; they’re designed to bracket overnight rates in the $5-trillion-a-day repo market, keeping rates largely within the Fed’s 25-basis point range: at the low end (currently 3.75% via ON RRPs) and at the high end (currently 4.0% Discount Window and SRF).
There are discussions underway at the Fed to switch the Fed’s target range from the federal funds rate to a repo rate.
Dallas Fed president Lorie Logan – a leading voice on the nuts and bolts of the Fed’s market operations due to her prior job as head of the New York Fed’s System Open Market Account (SOMA) – has been publicly advocating to shift the target range from the fed funds rate to the Tri-Party General Collateral Rate (TGCR), which is a “cleaner” rate, as she says, than the Secured Overnight Financing Rate (SOFR).
And she has been blasting the federal funds rate. In her speech on Friday, she said:
“In my view, the fed funds operating target is outdated. The fed funds rate measures rates on unsecured, overnight loans between banks and other entities, such as FHLBs, that hold reserves. This rate made sense as an operating target given the way money markets worked in the 1990s, when the FOMC began publicly targeting fed funds. However, the world has changed since then….”
“Today, the fed funds market is dominated by an arbitrage trade. FHLBs, which don’t receive interest on reserves, lend to foreign banks, which receive interest on reserves but don’t pay for deposit insurance. This concentrated base of lenders and borrowers makes the fed funds market idiosyncratic and fragile.
“Fed funds rate appears to act more like a lagging average of past money market pressures than a timely indicator.
“From July 2023 through mid-September of this year, the spread of the fed funds rate to IORB [Interest on Reserve Balances] didn’t change by a single basis point even as money market conditions fluctuated meaningfully and other money market rates moved in response. More recently, the fed funds rate has come up only gradually despite large daily swings in repo rates.
“In addition, any change in the FHLBs’ incentives or funding demand can cause fed funds volume to drop sharply, as occurred when FHLBs needed to meet higher advance demand during the March 2023 banking stresses.”
If the connection between the federal funds rate and repo market rates breaks entirely, the Fed will have to adopt a different rate measure for its target range, such as TGCR (Logan’s preference) or SOFR, and do so suddenly under time pressure. But Logan warns:
“I don’t think making important changes under time pressure is the best way to promote a strong economy and financial system…. Proactively changing to a more robust target, such as TGCR, would allow time for a smooth transition so the private sector could adjust.”
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Here is my quick take which is a more broad criticism of targeting short rates or rather how the Fed’s impact by targeting that rate has dwindled over time. In 1980, Treasury securities were circa 65% of all fixed income, now they are 20% ish. And of course, their impact is largely short rates, with some knock on effect for rates down the curve but even less for credit. Moreover, it seems as if the main game in town is how financial conditions drive the economy, which in theory should be good news for the Fed but in reality, as indicated, their power to influence is less. Finally, we have to bear in mind the Goodhart law, when something becomes a target, it ceases to be useful.
Good comment, but…
“…the Goodhart law, when something becomes a target, it ceases to be useful.”
I cannot believe that this BS keeps getting repeated. The “Law” had to do with corporate motivation, such as creating a productivity measure that employees have to hit, and that employees then game (bad employees will game anything, target or not). It is silly to apply this stuff to finance – or to anything else.
great article
“But during the Financial Crisis, unsecured interbank lending contributed to contagion, as banks suddenly stopped lending to each other, and that daily funding mechanism banks had relied on for decades suddenly dried up, and banks had trouble funding their daily short-term needs. The Fed stepped in with QE and the federal government with a bailout and new regulations.”
I think that is an accurate account of the great swindle, unwinding.
thanks for the article.
Yep, with new “tricks” need new measures;-).
Very informative article.
It makes we wonder and suspect the Fed somehow is protecting reckless behavior, providing backstops for those reaching for funds at the 11th hour.
The users of the Discount window are hidden for months. Are the activities of tri party deals public or other activities in the SOFR or SRF?
Are these players working so close to the “edge” that they must reach for funds at the last minute and pay over the SRF rate?
Are these players and users of these Fed mechanisms the “gunslingers” that caused 2008?
Your thoughts.
The Fed’s classic job is to provide short-term liquidity to the banks whenever. But it’s not free. The Fed charges 4% currently for this liquidity. The Discount Window has been around forever. You benefit from this liquidity as your bank doesn’t collapse every time it runs short on liquidity. Banks borrow short (depositors can withdraw funds any time) and lend long (loan funds are committed for years), which is systematically risky, and a reliable source of instant liquidity is crucial for a banking system to operate safely. And the banking system allows this website to be up and running, and it allows you to post this comment. Without a reliable banking system, none of it would exist.
“Are these players working so close to the “edge” that they must reach for funds at the last minute and pay over the SRF rate?”
Here’s a different way to look at it: the Fed *doesn’t want* banks to pay over SRFR because that’s how they bracket short rates. Additionally, modern-day balance sheet constraints require banks to work “close to the edge” – notice most of the SRF usage is at quarter-end when banks need to window dress.
I assume there was some point in time where the repo market became so automated and frictionless that secured overnight lending became as easy as unsecured. At which point there was little need for unsecured other than old momentum and investments.
Wolf.
Why would a commercial bank borrow from another commercial bank at a rate substantially higher than the rate at discount window or SFR rate. ?
When SOFR rate exceeds SFR , this is sign of that interbank lending happening?
If liquidity is tight today where are the $7T in MMMFs going. Are they already being used to partially fund commercial banks?
Are MMMFs mostly funding non bank commercial paper directly?
Has there ever been a thought to limit MMMFs investments to the Fed repo, or directly commercial banks repo to keep the monies in the “banking system”?
Thx
When liquidity is needed, and the Fed offers a mechanism to relieve that illiquid situation….
is something out of balance?
Are the users of these overnight borrowing operations “surprised” by the condition in which they find themselves? Mismanagement? Overextended?
The money supply, choose your metric, is massively higher than just a few years ago…….didnt the Fed make moves to increase the money supply? Isnt that liquidity?
Whenever I hear “Hey, I need a quick loan” It suggests something is awry.
Just IMO.
Normally, including currently, the unsecured interbank lending rate EFFR is lower (3.87% on Thursday) than the secured lending rates at the Discount Window (4.0% now) and SRF (4.0% now).
Borrowing from another bank at 3.87% doesn’t require collateral, while borrowing from the Fed at 4.0% requires collateral. So in theory, interbank lending has two advantages for the borrower: no collateral and a lower rate.
But for the lender, those two are disadvantages. And why lend to another bank unsecured at 3.87% and take a risk when you can keep the cash at the Fed as reserves and earn 3.90% risk-free?
Wolf, do you suspect “stress” in the system when there is a spike in the SRF?
By stress I mean institutions playing too close to the edge of what might be considered conservative and responsible finance.
ie , would it be a precursor of something to come?
No, the SRF is doing what it is intended to do as QE liquidity is getting removed, and what the Fed has exhorted banks to do with it. There is still a huge amount of liquidity out there, but since no one has had to manage liquidity in five years because there has been an endless supply, financial firms got out of practice. So they’re relearning.
There is a lot of inane BS about this on Bloomberg and elsewhere because they all pushed as hard as they could for over three years to end QT because everyone on Wall Street hates QT. They did the same with tariffs, just spreading fearmongering BS about tariffs to somehow stop them.
“When SOFR rate exceeds SFR , this is sign of that interbank lending happening?”
SOFR > IORB is a sign banks are deploying funds into repo mkts.
Many things are out of normals for example the SP 500 closed OCT at an all time high as measured in its monthly close. However, Only 53% of the sp 500 companies are above their 200 Day EMA and 43% above its 50 D EMA. You don’t see that often or maybe ever. The lady from Texas is smart, crush worthy smart on her articulate thoughts!
Dumb question: other than potentially ending the FHLB arbitrage, how is this anything other than a simple name change?
The Fed already adjusts the other rates when adjusting EFFR, and the unsecured interbank market hasn’t been relevant since the GFC. Can’t they just… call TGCR the new policy rate and then move on with their day? I must be missing something.
So the rate that the Fed uses for its target range (currently EFFR) is a measure of whether or not the other four rates are doing their jobs keeping the repo rates within the target range. The EFFR has disconnected from the repo market. Repo rates spiked while the EFFR didn’t really react except belatedly one tiny bit. So it now longer functions as a measure of how closely the Fed is able to control overnight rates.
Logan obviously didn’t do the grunt work and is more involved in high level thinking.
The FED shouldn’t have stopped QT. Gdpnow’s growth rate is at 4 percent.
You have floors draining reserves while ceilings injecting reserves. What could go wrong?
No different than the FED Funds bracket racket of the 60’s & 70’s.
The Keynesian technicians in charge of the daily administration of open market operations apparently believed that there is, at any given time, a repo rate that was consonant with a proper rate of change in GDP. They plugged this concept into a computer model.
What the Fed’s research staff actually “plugged in” is an open-ended device through which the commercial banks could decide whether or not there should be an expansion in the legal lending capacity of the banking system – the capacity to create credit (money) and to acquire additional earning assets.
This assures the bankers that no matter what lines of credit they extend, they can always honor them – since the Fed assures the banks access to free reserves whenever the banks need to cover their expanding loans – deposits.