Options for modernizing the FOMC’s operating target interest rate

Core Points - The Federal Open Market Committee (FOMC) is evaluating whether the federal funds rate remains the appropriate operating target for short-term interest rates, given the evolution of the financial system and money markets [1][2][3] Group 1: Historical Context and Evolution - The FOMC has historically adapted its operating targets to maintain influence over monetary conditions as the financial system has evolved, indicating a need for potential updates to the current target [3][4] - The transition to targeting the fed funds rate in the mid-1990s was a response to changes in the economy and financial system, making it a useful indicator of monetary conditions [12][19] - The Fed's operating targets have shifted over time, reflecting different economic goals, such as controlling inflation and stabilizing the macroeconomy post-World War II [10][11] Group 2: Changes in Money Markets - Since the mid-1990s, the money markets have undergone significant changes, with collateralized financing becoming more prevalent than uncollateralized interbank loans, diminishing the relevance of the fed funds market [4][21] - The volume of transactions in the fed funds market has decreased, with daily volumes now around $100 billion compared to over $4.5 trillion in repo markets, indicating a shift in market dynamics [28][29] - Regulatory changes post-Global Financial Crisis have further reduced the attractiveness of unsecured interbank lending, leading to a preference for secured funding [22][23] Group 3: Fragility of the Fed Funds Market - The connections between the fed funds market and broader money markets have become fragile, raising concerns about the effectiveness of the fed funds rate as an operating target [5][31] - The concentration of major lenders in the fed funds market, primarily the Federal Home Loan Banks (FHLBs), creates vulnerabilities that could impact monetary policy implementation [34][35] - A lack of trading volume in the fed funds market could lead to disconnection from other money markets, undermining its usefulness as a gauge for broader monetary conditions [36] Group 4: Alternative Operating Targets - The essay discusses potential alternative operating targets, including repo reference rates, which may provide more robust measures of monetary conditions than the fed funds rate [6][38] - Targeting a Treasury repo rate, such as the tri-party general collateral rate (TGCR), is proposed as a viable option due to its strong connections to broader money markets [52][60] - The Secured Overnight Financing Rate (SOFR) is also considered, but it may not provide as clean a gauge of liquidity costs as TGCR due to its combination of different market segments [57][58] Group 5: Benefits and Costs of Transitioning - Proactively transitioning to a different operating target could mitigate risks associated with the fragility of the fed funds market, although it would incur transition costs [68][69] - The effectiveness of policy transmission and the need for a well-developed understanding of the new target would be critical for successful implementation [70]