(Bloomberg Opinion) -- Adjusting interest rates has long been the Federal Reserve’s primary tool for managing the U.S. economy. But as the way in which the Fed implements monetary policy changes, it needs to consider changing the interest rate it targets.
For many years, the Fed has focused on the federal funds rate, the overnight rate at which banks lend each other cash reserves that they keep at the central bank. By manipulating the amount of reserves available, the Fed would cause the rate to rise or fall, and this would affect interest rates more broadly throughout the economy.
In recent years, though, the federal funds rate has become less relevant. For one, the Fed’s securities purchases — known as quantitative easing — have left banks with ample excess reserves, on which the central bank now pays interest. So banks no longer have much need to borrow or lend federal funds. This has caused the market to shrink significantly. It now consists largely of lending from institutions that aren’t allowed to earn interest on cash balances held at the Fed — such as Fannie Mae and Freddie Mac — to banks that are. So the market is not only smaller, but has also changed in a fundamental way.
In this new regime, the interest rate on reserves has become the Fed’s most effective tool of monetary policy, putting a floor under the interest rates at which banks are willing to lend. In this new regime, setting a target for the federal funds rate has become superfluous, and at times even a nuisance. Over the past year, for example, the Fed has had to make small technical adjustments to the interest rate on reserves to reduce the risk that the federal funds rate might inadvertently climb above the top end of the Fed’s target range.
In fact, some analysts see a possibility that the Fed might decide to make such a technical adjustment at this week’s policy-making meeting. Officials could decide to cut the interest rate on reserves slightly because the federal funds rate has drifted above it — to the extent that it is now just several hundredths of a percentage point away from the top of the central bank’s target range of 2.25 to 2.50 percent.
So why not jettison the federal funds target, and just use the interest rate paid on reserves? There is really no compelling objection. The interest rate on reserves is already the key short-term rate, so the change would have no meaningful effect on the Fed’s monetary policy stance. It would also make things simpler and more transparent by eliminating the need for technical adjustments to the interest rate on reserves to ensure that the federal funds rate stays within its range.
The main impediment has to do with governance. The Federal Open Market Committee, which is responsible for monetary policy, naturally doesn’t want to delegate power to the Board of Governors, which has the statutory authority to set the interest rate on reserves. But this obstacle could easily be overcome: The committee could just ask the board to adopt its recommended rate. It’s hard to imagine the governors not going along, especially given the overlap in leadership and membership.
I don’t expect any change soon. The Fed is a naturally conservative institution. But I would encourage officials to think about it. As a monetary policy target, the federal funds rate has outlived its usefulness. Why not recognize this officially?
To contact the editor responsible for this story: Mark Whitehouse at mwhitehouse1@bloomberg.net
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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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