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Is It Time to Ditch the Fed-Funds Rate?

Fed officials discussed alternatives to the benchmark rate, minutes show

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The Federal Reserve building in Washington. Photo: Andrew Harrer/Bloomberg News

By

Katy Burne

Updated Nov. 23, 2016 5:33 p.m. ET

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Federal Reserve meeting minutes show the central bank discussed alternatives to the interest-rate benchmark it has been using for decades just as it is widely expected to raise the rate next month.

Minutes of the Nov. 1-2 interest-rate-setting Federal Open Market Committee meeting, released Wednesday, reveal that the Fed has been weighing benchmarks to replace its effective federal-funds rate if certain scenarios were to develop, such as an environment where short-term interest rates are apt to gyrate more frequently.

Regardless of the level of bank reserves in the financial system, the policy rate “could be an unsecured overnight market rate or an interest rate administered by the Federal Reserve,” according to the minutes.

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Policy makers added in the minutes, “The FOMC might instead target an overnight Treasury repurchase agreement rate.” The Federal Reserve Bank of New York earlier this month said it was considering publishing such a rate, although a parallel one already is published elsewhere.

“It certainly sounds like they are open to considering an official rate that is something other than the federal-funds effective rate,” said Mark Cabana, head of U.S. short interest rate strategy at Bank of America Merrill Lynch and a former New York Fed official.

The fed-funds rate serves as a benchmark for rates across the rest of the financial system, so when the Fed lifts the benchmark, it tends to push up rates on everything from mortgages and auto loans to the cost of financing the U.S. government.

The fed-funds rate also has been used for decades to measure rates on overnight loans between banks, as well as to price trillions of dollars of derivatives and securities transactions.

The Fed has been committed to keeping the fed-funds rate as its policy rate for decades. But a number of Fed watchers, some of whom used to work at the central bank, this year have argued the central bank will need to change it.

The idea of replacing the fed-funds rate featured in a presentation from Brian Sack, former head of markets at the New York Fed, to three dozen central bankers, academics and financial-market practitioners gathered at Columbia University in May.

One of his slides said the federal-funds market, where financial institutions swap overnight funds, has “a limited amount of activity” and the “Fed should consider an alternative target variable.”

A spokeswoman for the New York Fed declined to comment on any potential switch. A Federal Reserve Board spokesman declined to elaborate on the minutes or the discussion.

The Fed has looked to hit a policy target by buying and selling government securities for most of its history. Walker Todd, lecturer at Middle Tennessee State University and a former Fed lawyer, said the central bank targeted a policy rate from its creation in 1913 to the present, with the exception of a period from 1979 to 1984 when it targeted the extent of money supply in the banking system.

Traders and analysts have complained that trading isn’t deep enough to make the fed-funds rate a robust enough policy rate.

“As a result of shrinking activity in the federal funds market, we expect that one key change will be a switch in the Fed’s official policy rate,” wrote Elad Pashtan, a senior U.S. economist at Goldman Sachs Group Inc., in client note earlier this year. Previously, he was a Treasury markets analyst at the New York Fed.

Zoltan Pozsar, director of economics at Credit Suisse Group Inc. and a former New York Fed markets official, wrote in a similar client note this year: “The Fed will have no choice but to switch to a new target rate.”

The benchmark has fallen into unusual patterns in recent months, holding steady much of the time and then tumbling at month’s end.

Mr. Pozsar said new regulations and market distortions are “taking the life out of what once was a vibrant market” and have kept the fed-funds rate artificially around 0.37%, when a rate that is more alive should be more of a wiggly line.

Part of the reason for that is excess liquidity in the banking system. The excess has caused fed-funds transaction volumes to thin out in recent years, because most large U.S. banks no longer are seeking overnight loans the way they used to.

The remaining lending in fed funds is dominated by a small subset of firms. Trading in the fed-funds market now averages $70 billion a day, down from $200 billion in 2007.

The FOMC, which would have the task of deciding on any change in the target rate as a policy directive, hasn’t expressed a desire to switch, only that it is considering potential alternatives. There also may be no urgency because the central bank considers the fed-funds rate to be working for its monetary policy purposes for now.

Discussion of alternatives to the fed-funds rate come as the central bank is weighing potential alterations to its longer-run interest-rate policy framework, a topic the FOMC last touched on at its July meeting.

Those talks have included the merits of keeping a larger balance sheet, instead of shrinking it back to pre-2008 levels, and more regular large-scale asset purchases. Not returning the size of the balance sheet to precrisis levels would give the central bank the flexibility to buy and sell bonds whenever it wants.

In the minutes, policy makers “agreed that decisions regarding the long-run implementation framework were not necessary at this time.” The Fed also said it would “would proceed cautiously and would communicate any intended changes to its approach to implementing monetary policy well in advance of making the changes.”

Write to Katy Burne at katy.burne@

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