LORIE Logan, president of the Federal Reserve Bank of Dallas, has proposed replacing the central bank’s benchmark federal funds rate – the primary tool the central bank has used to steer the nation’s economy since the 1980s – with a much more widely used market bellwether.
In a speech delivered on Thursday and in an accompanying essay, Logan unexpectedly rekindled a debate that market participants say is long overdue.
“We have been long advocating for the Fed to shift the policy target away from fed funds to repo and this is a step in the right direction,” said Mark Cabana, head of US interest rate strategy at Bank of America. “Why is it Lorie? Because no one is doing anything about it. She needs to get the ball rolling. She’s effectively done that with this speech.”
At stake is whether the central bank is tying its benchmark rate to a vital enough market that captures the push and pull of short-term funding needs across the entire financial system.
The federal funds market, where banks once lent to each other on an overnight basis, has largely shriveled. It’s been supplanted in the last 15 years by the market for repurchase agreements, another form of short-term lending.
That market is open to a broader array of financial participants and offers more attractive rates. That means shifting away from the fed funds rate would allow the Fed to operate in a more stable and established market, potentially increasing the effectiveness of monetary policy.
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“The time has come for the FOMC to prepare to target a different short-term interest rate,” Logan said on Thursday in prepared remarks for an event at the Richmond Fed, referring to the Fed’s policy-setting Federal Open Market Committee.
Logan argued the fed funds target is outdated, and connections between the little-used interbank market and overnight money markets are fragile and could break suddenly.
Updating the mechanisms by which the Fed implements monetary policy would be part of efficient and effective central banking, she said.
Move before it breaks
Market participants have for years called for the Fed to move away from the fed funds rate and to another benchmark, and Fed officials have studied doing so in the past, including during a review of its monetary policy implementation tools in 2018. Logan noted that the time to make such a change is when markets are stable.
“One might say that since all is fine for now, there’s no need to act. But if transmission between fed funds and other money markets ever broke down, we’d need to quickly find a replacement target,” Logan said. “And I don’t think making important decisions under time pressure is the best way to promote a strong economy and financial system.”
Before taking the helm of the Dallas Fed in 2022, Logan spent more than two decades at the New York Fed’s markets desk – ultimately rising to manage the central bank’s balance sheet.
She has frequently commented on financial-market matters including stability and liquidity issues and is considered a leading voice within the Fed on such topics.
Logan offered a variety of ways in which the Fed could ensure interest rates stay within their prescribed range but said the tri-party general collateral rate, or TGCR, could offer the most benefits.
The TGCR is one of three rates tied to overnight repurchase agreements – in addition to the widely used Secured Overnight Financing Rate – and overseen by the New York Fed.
Market participants have argued the TGCR would be an ideal fed funds replacement as it represents a more robust lending market. It fixed at 4.12 per cent as of Sep 24, up from 4.09 per cent the prior session, data show.
Moribund Fed funds
Logan noted the TGCR incorporates more than US$1 trillion in daily transactions, so changes would transmit well across money markets. Fed funds volumes are currently averaging less than US$100 billion.
The fed funds market was once the principal one for overnight loans between financial institutions. It thereby signalled changes in financing conditions that could affect longer-term lending rates for businesses and consumers.
But massive monetary stimulus during the financial crisis and the pandemic left the country’s banking system awash in dollars, much of which are parked at the Fed.
That has largely eliminated the need for banks to borrow and lend amongst themselves as they sought to maintain minimum reserve requirements.
Now, the market is driven primarily by a small group of participants, so it doesn’t accurately reflect the market as a whole, Cabana said.
“The shift in private activity toward secured markets makes it very likely, in my view, that the target rate will eventually need to change,” Logan said. “If the target rate must change, the best time for a change would be when markets are functioning smoothly and market participants can have plenty of advance notice.”
The Dallas Fed chief also emphasised that a process of replacing the fed funds rate wouldn’t interfere with the Fed’s current programme of winding down its balance sheet, nor have broader implications for its monetary policy strategy.
Fed watchers regard the benchmark as a tool for managing the flow of credit to the economy. However, the real controlling valve now is a set of rates determined by policymakers known as administered rates, which include the rate of interest on reserve balances, or IORB.
“It makes a lot of sense to move away from the fed funds market and into repo, as the latter is larger by orders of magnitude,” said Jan Nevruzi, a strategist at TD Securities. “Day-to-day volatility in repo is larger, but it is informative,” whereas “fed funds is very sticky until it’s not,” Nevruzi said.
While fed funds is designed to fluctuate within a 25-basis-point target range, until this week it had barely oscillated over the past two years, except when the Fed itself adjusted policy rates. It ticked up to 4.09 per cent on Sep 22, from 4.08 per cent, and has held steady this week.
The TGCR, by contrast, does move around on a daily basis, and Logan said it would be fine for it to continue to do so – as long as it stays within the quarter percentage point range set by the Fed, should it become the primary policy tool.
“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,” Logan said.
Other Fed officials have noted the problems associated with the fed funds market.
Roberto Perli, who replaced Logan at the New York Fed as manager of the central bank’s portfolio of securities, has previously described fed funds as one indicator among others of money-market conditions, including domestic borrowing and intraday bank overdrafts. But at an event in March, Perli acknowledged the rate doesn’t respond to everyday changes in reserves.
Beth Hammack, who spent three decades at Goldman Sachs before becoming president of the Cleveland Fed last year, has also said policymakers should be questioning the relevancy of targeting the fed funds rate.
“It’s obvious that the fed funds rate is not the appropriate rate for steering US monetary policy because it’s not used very much,” said Darrell Duffie, a finance professor at Stanford University.
“It’s clear that it’s the tail wagging the dog, and we should be doing what President Logan suggested and using a much more robust and important indicator of borrowing and lending conditions in wholesale financial markets,” he said. BLOOMBERG
