Target a Range or Target a Point? Fed May Soon Revisit Approach

(Bloomberg) -- There’s a certain awkwardness to the Federal Reserve’s benchmark interest rate.

Unlike most other major central banks, the Fed doesn’t use a simple, single rate but rather sets its target as a range. And so when policy makers raise borrowing costs -- as they did in March -- it can read like a jumble of numbers. In last month’s case, the rate went from a minimum of 1.25 percent and a maximum of 1.5 percent to a minimum of 1.5 percent and maximum of 1.75 percent.

The current system was created during the depths of the financial crisis a decade ago. Its adoption allowed the Fed to avoid cutting the benchmark rate all the way to zero, which officials saw as potentially dangerous. (They initially settled on a range of zero to 0.25 percent.) And then, when they began lifting borrowing costs years later, it made sense to stick with the range because there were new and unknown variables at work and they weren’t sure how precisely they could control the rate.

But now, as the Fed’s balance sheet shrinks and market rates creep higher, there is talk in some of the more wonkish corners of Wall Street about a return to the old system. It won’t likely happen anytime soon -- certainly not at next week’s Fed meeting -- but the conversation will only pick up steam as financial conditions continue to normalize.

“The issue is putting itself on the agenda sooner than I’d expected,’’ said Lou Crandall, chief economist at Wrightson ICAP in Jersey City and a former researcher at the Federal Reserve Bank of New York. That’s because as the Fed’s recent actions have drained cash from the financial system, the fed funds rate -- which banks charge each other for short-term loans -- has been climbing. If it continues higher and threatens to break through the upper end of the range, a move back to a single-rate benchmark would make sense, Crandall said. “It’s kind of silly to put out a quarter-point target range that you might miss.”

Radical Change

As odd as the current system may seem, the Fed actually flirted with a more radical change back before making the switch in December 2008.

The Federal Open Market Committee discussed temporarily abandoning the target rate altogether and instead issuing a more generic pledge to maintain low rates for a while. In the end, when the committee opted for the target range, some officials argued for a return to a single rate when possible. It’s a “much better way to communicate policy,” James Bullard, president of the St. Louis branch, said at the meeting.

In coming months, the point-versus-range conversation could be tied to a more substantial debate about which system the Fed should use longer-term. Back in 2008, the adoption of a target range was accompanied by a switch in the mechanism that ensures the fed funds rate hovers near target. Called the “floor” system, it uses the interest rate the Fed pays banks for excess reserves as an upper bound.

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The old mechanism used alongside the single-rate system -- known as the “corridor’’ -- was predicated on maintaining scarce reserves and then using open-market operations to guide the rate toward the target.

Many Fed officials argue the floor mechanism gives policy makers more flexibility and would allow them to return more easily to a bond-buying program if needed to bolster the economy. Chairman Jerome Powell is among its fans. The corridor “may be less robust over time,” he said in 2017.

The Fed hasn’t said when it will decide, but it will have to discuss the issue before long. Balance sheet run-off is currently on autopilot without a clear endpoint, and if reserves shrink too much, the floor system will no longer work.

Of course, there’s nothing stopping policy makers from keeping the floor mechanism in place but still shifting back to a single-rate target. It’s never been done before, but Michael Feroli, the chief U.S. economist at JPMorgan Chase, says that shouldn’t be an issue.

“You could do it with either a corridor or a floor; I don’t think the two issues need to inherently be linked,” says Feroli, who was a Fed Board economist before the crisis. “We went to a range when we didn’t know how the floor worked. Now, with more experience, we’re learning that the effective funds rate is actually more stable in the current regime.”

Crandall suspects Fed members will discuss the topic at policy meetings this year. And the Fed’s Summary of Economic Projections appears to show that at least two officials expect a return to the single-rate system by 2020. One member even seems to expect a point target to come back next year.

The single-rate target is “what they know,” said Gennadiy Goldberg, a rates strategist at TD Securities in New York. “It’s a more simple way of central banking.”

©2018 Bloomberg L.P.

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