“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.