Shrinking Liquidity and the Challenges of Measurement

Idle cash sloshing around the U.S. financial system is projected to contract in the coming months, reigniting a debate about how to assess the degree of monetary tightness and exactly which benchmark interest rates the Federal Reserve should target. A chorus of voices, including Cleveland Fed President Loretta Mester, have pointed to the limitations of the federal funds rate, with some even suggesting the Fed should abandon it in favor of other gauges.

The Federal Funds Rate's Limitations

The federal funds market, once an active channel for overnight bank borrowing, used to foreshadow tightening funding conditions. But massive monetary stimulus during the financial crisis and the COVID-19 pandemic flooded the U.S. banking system with dollars, leading banks to largely exit the federal funds market and instead park cash directly at the Fed.

Potential Alternatives: SOFR and Repurchase Agreements

Today, average daily borrowing in that market is about $110 billion, or about 0.5% of commercial bank assets, well below the roughly 2% level before 2008. By comparison, Treasury-backed repurchase agreement transactions, which form the basis of the secured overnight financing rate (SOFR) and other repo benchmarks, amount to trillions of dollars. SOFR reflects liquidity movements more accurately than the federal funds rate, making it an attractive alternative.

Impact of Debt Ceiling and Balance Sheet Reduction

With the U.S. Congress having raised the debt ceiling by $5 trillion—likely leading to increased Treasury bill issuance—at the same time that the Fed is shrinking its balance sheet, the issue is again coming into sharp focus and may cause some turbulence in funding markets.

Administered Rates as Liquidity Control Tools

Fed watchers see the federal funds rate, which the central bank has relied on since the 1980s, as a tool for managing the flow of credit into the economy. However, the real control valve now consists of a series of rates set by policymakers, including the interest rate paid to banks that park cash at the Fed, known as the interest on reserve balances (IORB).

Concerns About Funding Pressures

Because the federal funds rate is sluggish in responding to changes in liquidity conditions, market participants worry it won’t foreshadow bigger stresses. Similar funding turmoil occurred in 2019 when the Fed rapidly shrank its balance sheet. At the time, a scarcity of bank reserves led to a sharp spike in a key lending rate, forcing officials to intervene.

Alternative Proposals

A report by the Group of Thirty, led by former New York Fed President William Dudley, suggested the Fed’s Open Market Committee should stop announcing a range for the federal funds rate and set monetary policy targeting the interest rate on reserve balances (IORB). Richard Clarida, a former Fed Vice Chair, argues that what's important is how a range of short-term rates trade in relation to each other.

Conclusion

The question remains whether the federal funds rate is still an effective tool for measuring and managing liquidity in the U.S. financial system. With increasing evidence that other indicators, such as SOFR and repo benchmarks, more accurately reflect market conditions, it may be time to re-evaluate the role of the federal funds rate in guiding monetary policy. Understanding these dynamics is crucial for navigating the complexities of the modern financial landscape and anticipating potential market shifts. Further analysis of these indicators can provide valuable insights into the overall health and stability of the economy.