Options for modernizing the FOMC’s operating target interest rate
Lorie Logan and Sam Schulhofer-Wohl
We make four points:
First, the Fed has repeatedly evolved its operating targets to maintain influence over monetary conditions as the financial system evolved. Updating the target again to reflect how the financial system has changed in the decades since the FOMC began targeting the fed funds rate would continue that longstanding practice.
Second, money markets have changed greatly since the FOMC began publicly targeting the fed funds rate in the mid-1990s. Fed funds is a market for uncollateralized overnight bank funding. Uncollateralized interbank loans are far less important to the financial system than they once were, overtaken by collateralized, or secured, financing.
Third, while the fed funds target continues to give the FOMC effective control of broader monetary conditions, connections between the fed funds market and broader money markets have grown fragile. If fed funds were to disconnect from broader money markets, the FOMC could need to rapidly adopt a new operating target. We argue that instead of waiting for an urgent need, the FOMC should change proactively and planfully to a different target rate.
Fourth, the cost of proactively switching to a different operating target is not high. Other rates are readily available, particularly repo reference rates, that would provide more robust targets than fed funds. Because fed funds is currently well connected to other rates, targeting a different rate need not disrupt monetary policy communications or money market conditions. By maintaining a target range and allowing the target rate to fluctuate within a band, the Fed can target a repo rate without large, frequent and complex market interventions. Changing proactively would reduce the risk of having to adopt a new target during a period of economic or market stress. A proactive move would also allow the FOMC to announce the transition well in advance so market participants could prepare.
The full paper is available here.