What will the Fed use as its operating target?
In 2012, the Federal Reserve’s Open Market Committee (FOMC) clarified its long-run goals of price stability and maximum sustainable employment in a strategic statement that included for the first time a numerical inflation objective. While these ultimate objectives have evolved over the years, the FOMC’s operating instrument has been unchanged at least since 1981, when it began to target the federal funds rate -- the overnight interest rate on unsecured interbank loans. Since December 16, 2008, the target has been 0.00 to 0.25 percent, effectively at the zero lower bound for nominal interest rates. The history of the federal funds rate target is shown in the accompanying figure (and here).
When the FOMC starts to raise interest rates sometime in the next few years, will it continue to use the federal funds rate as its operational target? Or, will the Committee change its target interest rate to something else?
We suspect that a change in the operational target is now more likely than at any time in decades. The reason is that the market for unsecured interbank lending remains impaired nearly five years after the financial crisis of 2007-2009 ended, with little prospect for self-repair. The decline of the federal funds market naturally diminishes the usefulness of the fed funds rate as a policy tool.
Why was the federal funds market so important before the crisis? At that time, the Federal Reserve’s assets were in the range of $900 billion, but the vast majority of Fed liabilities, around $800 billion, was currency. Consequently, bank reserves held at the Fed usually amounted to less than $10 billion. In fact, in the five years prior to the crisis, reserves never exceeded $25 billion.
In managing their reserves, banks have two simple objectives. First, they need to meet their reserve requirement over the two-week averaged maintenance period. Second, they have to end every day with a positive balance in their reserve account, or face a stiff penalty. With overall balances in the system so low, banks needed to reallocate reserves among themselves every day to meet these two objectives. These needs gave rise to the federal funds market, which had transactions of more than $200 billion per day, a large multiple of actual reserves.
However, since the crisis intensified in late 2008, things have changed dramatically. Today, the Fed’s balance sheet is over $4 trillion and the vast bulk of the increase in Fed liabilities is in the form of reserves. As of February 2014, bank reserves stood at more than $2.5 trillion! (Currency holdings also have risen, but only to $1.2 trillion.) With reserve levels so high, banks have no trouble meeting their slim reserve requirements, nor do they have to worry much about overdrawing their reserve account at the end of the day. Not only that, but because of the experience during the crisis itself, banks are wary of making unsecured loans.
As a result, the federal funds market has collapsed to roughly one-fifth of its earlier size (see chart). Now, on a typical day, domestic and foreign banks operating in the United States borrow only about $55 billion! (The split is about one third domestic and two thirds foreign.)
It wouldn’t make much sense for the FOMC to target an interest rate that is irrelevant to the financial system. So, what will they do? The answer is that they need to find an interest rate that they can control and that has strong links to financial conditions in the economy as a whole. Our candidate is the overnight repo rate.
Over the past few months, the Fed’s Open Market desk has been designing and testing systems that will allow it to conduct reverse repurchase agreements on a large scale. You should think of a repo as a secured loan. In a reverse repo, the Fed provides securities and receives cash (reserves). While the Fed often used repos and reverse repos in the past to manage small, temporary adjustments to the supply of reserves, the purpose of these new arrangements is to be in a position to drain a large volume of reserves from the banking system on a sustained basis, thereby reducing significantly the level of excess reserves. The Fed could do this by setting a fixed rate for repo, and then offering securities in exchange for reserves in whatever quantity banks would like to supply. That is, the Fed will have the capacity to target the overnight repo rate.
Why should they choose this tool? In theory, the Fed could try to resurrect the unsecured interbank loan market. But we know that market is fragile, collapsing at the worst possible time, fueling financial instability. Instead, the Fed could encourage a more stable financial system by pegging a secured lending rate that provides a more robust anchor for lending among financial firms.