The Fed’s Interest Rate Target Is Obsolete
(Bloomberg Opinion) -- The U.S. Federal Reserve’s interest-rate decisions have big repercussions for the country and the world. Yet the short-term interest rate it targets — known as the federal funds rate — no longer plays a meaningful role in the economy, and requires occasional fiddling to keep it in line.
The simple solution: Drop the target.
Once upon a time, the fed funds market mattered. It’s where banks would go to borrow money from each other to ensure they had enough cash at the Fed to satisfy the central bank’s reserve requirements. By setting the fed funds rate, the central bank could define banks’ cost of short-term borrowing, which in turn would affect the interest rates on lending across the economy.
Now things are different. For one, the Fed pays interest on reserves, a guaranteed return that puts a floor under the rates at which banks lend elsewhere. Also, banks have a lot of excess reserves, thanks in part to the Fed’s asset purchases aimed at keeping longer-term interest rates low. As a result, the fed funds market has become a sideshow, where institutions that can’t receive interest on reserves — such as mortgage giants Fannie Mae and Freddie Mac — lend funds mostly to foreign banks.
This can create problems for the Fed. Recently, for example, a flood of reserves — related to the Fed’s continued asset purchases and the Treasury’s efforts to draw down the cash accumulated in its Fed account — caused the fed funds rate to drift downward toward the bottom of the zero-to-0.25% target range. To nudge it back upward, the Fed had to adjust two other rates: The rate on reserves, and the rate it pays to borrow cash in the repo market, where institutions such as money-market mutual funds lend cash against the collateral of Treasury securities.
The solution is simple: Stop targeting the fed funds rate, and set monetary policy using the interest rate on reserves instead. It’s a perfectly sufficient tool to keep short-term interest rates at desired levels. And there’s plenty of precedent for such a move. Before August 1997, the Fed’s monetary-policy statements didn’t refer to a fed funds target. Earlier in its history, the Fed had other targets, such as non-borrowed reserves and monetary aggregates.
To ensure the smooth functioning of money markets, the Fed should make one other change: Ignore reserves when calculating banks’ leverage ratios. Intended to act as a simple backstop to other capital requirements, the ratio has recently become a more binding constraint as ballooning reserves have caused banks’ leverage to rise — a problem that Fed Chair Jerome Powell noted in a recent press conference. This has caused some banks to turn away additional deposits in order to limit their reserves, putting downward pressure on short-term rates.
Including reserves in the leverage ratio makes little sense, given that the Fed, not banks, determines the level of reserves in the system. Also, they’re a completely safe asset, so removing them needn’t affect bank safety and soundness. To prevent the change from amounting to a loosening of capital requirements, regulators could adjust the required ratio so that banks’ collective capital requirements would not decrease.
With these two changes, the Fed would no longer have to tinker with the federal funds rate, simplifying both the conduct and the communication of monetary policy.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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