Fed Decides to Replace Key Rate
NEW YORK – December 12, 2018
The debate to replace the Federal Reserve’s key interest rate has begun, Bloomberg reports.
Spurred by declining volumes and the dominance of a few participants in the market for Fed funds, the central bank has started discussing potential alternative policy benchmarks as it seeks firmer control over the nation’s short-term interest rates.
While the deliberations have been largely overshadowed in recent weeks by speculation over a shift in the Fed’s tightening trajectory and the fate of its $4.1 trillion balance sheet, where they lead could have dramatic consequences for financial markets. Federal Open Market Committee members brought up two potential alternatives at last month’s meeting, and they could hardly be more different. What’s more, some strategists say a policy-targeting pivot could come as soon as next year.
“The Fed knows that Fed funds is flawed,” said Mark Cabana, head of U.S. interest-rate strategy at Bank of America Corp (NYSE:BAC). “It’s probably fatally flawed in their mind, and in the market’s mind.”
For most, Fed funds is synonymous with the central bank’s target rate -- yet it’s actually much more. It’s a market where financial firms make overnight loans to each other from the reserves they keep on deposit at the Federal Reserve Bank of New York -- ostensibly to ensure that they can meet critical overnight reserve requirements.
To control the effective Fed funds rate -- and in turn U.S. money-market rates broadly -- the Fed prior to the financial crisis used open-market operations to manipulate the scarcity of reserves available to be lent on any given day. The market’s dynamics changed, however, when quantitative easing measures intended to safeguard the economy created vast new bank reserves, lessening the need for firms to tap interbank liquidity.
Still, changes enacted at around the same time kept the market intact. New laws gave the Fed the power to pay some, but not all, institutions interest on excess reserve deposits kept at the central bank. Those without access opted to lend below the IOER rate, creating an attractive arbitrage opportunity for certain firms, which could borrow near the effective rate and park the cash at the New York Fed at IOER, pocketing the yield differential.
The onset of the Fed’s balance-sheet unwind has slowly begun to drain liquidity from the financial system, to the point where many in the market are suggesting bank reserves are once again poised to become scarce. In addition, a surge in Treasury-bill issuance -- and a corresponding increase in yields -- has helped push other key short-term rates higher, especially in the market for repurchase agreements.
Under these conditions, it became more profitable to place reserves not on the interbank market, putting upward pressure on the fed funds rate.
A turnover that once ran in the hundreds of billions of dollars a day has plunged to an average $64 billion this quarter, according to New York Fed data. It’s left the Federal Home Loan Banks -- a group of government-sponsored lenders -- as the dominant players in the market, unintentionally giving them outsized influence over where the fed funds rate settles.
Policy makers at their Nov. 7-8 meeting suggested that the Overnight Bank Funding Rate could potentially supplant fed funds as the target policy rate. Its appeal is plain to see.
Published by the New York Fed, the unsecured benchmark adds eurodollar transactions -- which are largely banks borrowing from non-bank financial institutions, like money-market mutual funds -- to the volume of daily Fed funds transactions that go into the calculation of the effective Fed funds rate, roughly doubling the daily turnover.
FOMC participants said last month that the similarity between OBFR and the Fed funds rate likely means there wouldn’t need to be significant changes in the way they conduct monetary policy were the central bank to make the transition. Yet some members also wanted to explore the possibility of using a secured rate, which would seem to open the door for SOFR, the Secured Overnight Financing Rate introduced earlier this year by the New York Fed in an effort to ultimately wean markets off their reliance on Libor.