Why the US federal funds rate may be out of step with the market
Observers worry the rate’s limitations make it ineffective in signalling larger funding pressures building within the financial system
AS POLICYMAKERS weigh the merits of lower US borrowing costs after the Federal Reserve cut its key interest rate in September for the first time this year, a new question is starting to gain urgency – whether the central bank is targeting the right benchmark rate in the first place.
Central banks seek to manage economies by setting interest rates at levels that encourage or discourage activities such as businesses investing in new projects or consumers buying homes and cars. For decades, the Fed has guided the economy by adjusting a rate that banks use to lend to each other for day-to-day needs in the so-called federal funds market. Historically, adjustments to the federal funds rate influence the amount of credit that flows into the economy, keeping it from running too hot or too cool.
At stake is whether the central bank is tying its benchmark rate to a vital-enough market that captures the true conditions in the plumbing of the financial system. Influential market observers have pointed out limitations in the federal funds rate since the Fed bought massive amounts of bonds during the 2008 financial crisis and again during the pandemic to stimulate the stagnating economy.
In September, Lorie Logan, president of the Federal Reserve Bank of Dallas, argued for replacing the rate with one that can better signal stress in overnight money markets and guide liquidity.
What’s the federal funds rate?
For decades, the federal funds rate was the interest rate that banks charged each other for overnight loans. It helped determine the cost of everything over the longer term, including credit card and auto loan rates and commercial borrowing. The Fed targeted a precise federal funds rate from the 1980s until the 2008 financial crisis, when it adopted a quarter-percentage-point range.
In recent years, the rate has become a signal of how the Fed perceives the economy rather than a rate at which banks tend to borrow and lend to one another.
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What role does the federal funds rate play in monetary policy?
The Fed uses the federal funds rate as its main tool to communicate its views about the trajectory of the economy.
Since the 1980s, the central bank has relied on the federal funds rate as its main benchmark rate to manage the flow of credit to the economy. The Fed adjusts the target range lower to stimulate the economy when employment growth and inflation are slowing, or higher to tighten conditions when the economy is running too hot, fuelling inflation.
While the rate is no longer used as actively between banks to lend to each other, it is still the main signal of the central bank’s intentions. Other interbank rates, as well as the secondary Treasuries market where most government securities are traded, adjust accordingly, helping to determine borrowing costs across the economy.
Why is the push to replace the benchmark rate coming now?
Massive bond-buying by the central bank during the 2008 financial crisis and the pandemic left the US banking system awash in dollars, leading banks to largely withdraw from the federal funds market and park their money directly at the Fed instead.
As a result, the federal funds rate is less effective in influencing overnight borrowing costs and is perceived to be slow in responding to changes in liquidity conditions. In the past couple of years, the rate has barely moved within its range outside of the Fed’s rate-setting cycles. Market participants worry the federal funds rate will not be effective in signalling larger funding pressures building within the financial system.
What alternatives exist?
Logan proposed two potential replacements: the Secured Overnight Financing Rate (SOFR), which is largely used for interbank transactions, and the Tri-Party General Collateral Rate (TGCR), both overseen by the New York Fed. She said the latter offers more benefits and represents a more robust lending market of more than US$1 trillion a day in risk-free transactions. By comparison, volume of trading in the federal funds market is currently averaging less than US$100 billion.
Other Wall Street strategists prefer SOFR as a broader benchmark for overnight markets. But this rate is also driven by supply-demand dynamics in the Treasuries market, including hedge-fund demand for financing leveraged trades, factors that would be outside of the Fed’s control, according to its critics.
How would the Fed change the benchmark?
Logan advocated starting the process to change the target rate while markets are stable. Communicating and adjusting to a new target rate could be more challenging for the Fed and market participants, and more disruptive to monetary transmission if the change occurred during periods of stress, she said.
Any shift from the federal funds does not mean that the rate would disappear. The Fed can begin targeting a wider set of money-market rates while still publishing the federal funds rate, given the reference to it in many financial contracts, according to Bank of America strategists Mark Cabana and Katie Craig. They expect any transition away from the federal funds rate to be slow and take at least a year. “Logan has a big hill to climb versus Fed institutional inertia,” they wrote in a note to clients.
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