Abandoning the Federal Funds Rate

Federal Reserve Board Building

Since the beginning of the great recession, the Federal Reserve has increased its transparency of monetary policy, created new tools for controlling short-term interest rates, and has maintained its dual mandate of fostering maximum sustainable output and employment with stable prices. The recent rise in the monetary supply and the increased size of the Fed’s balance sheet has been alarming for inflationary hawks. With an enlarged balance sheet, the federal funds rate may no longer be the most effective method for the Fed to control short-term interest rates. Two new tools: the interest on excess reserves held at the Fed, and the overnight reverse repurchase program could serve as a way for the Fed to directly control short-term interest rates and affect a larger number of market participants.

Traditionally, the Fed indirectly manages the federal funds rate in order to control short-term interest rates. The federal funds rate is the rate at which banks lend to each other for overnight loans in order to secure the amount of reserves required by the Fed. Since 2007, the Fed slashed the federal funds rate target from 5.25 percent to below ¼ of a percent in order to encourage lending and business investment during the recession.

After reaching the lower bound on the yield curve, the Fed created new tools in order to continue its expansionary stance on monetary policy. The Fed introduced three rounds of quantitative easing, consisting of purchasing millions of long-term treasury bills and mortgage-backed securities every month, in order to decrease medium- and long-term interest rates. The result of these purchases is a drastic increase in the size of the Fed’s balance sheet, which recently crossed $4 trillion and will likely continue to rise to a peak of about $4.5 trillion.

Former Fed economists, Brian Sack and Joseph Gagnon, recently published a paper proposing that the Federal Open Market Committee should stop targeting the federal funds rate as its benchmark interest rate, and instead use the reverse repurchase program in conjunction with setting interest on excess reserves at the same level.  Since 2008, the Fed has pumped $2.5 trillion into the economy by purchasing bonds on the open market. However, the traditional system will not work unless the central bank pulls out most of this money. This liquidity in the system will present a major challenge when the time comes to raise short-term interest rates. There is also economic evidence that a greater amount of liquidity in the financial system allows it to operate with less risk and greater efficiency, and therefore the Fed might not want to decrease its balance sheet even in the long run.

For monetary policy in the future, Sack and Gagnon have proposed that the Fed set short-term rates by directly controlling the interest on excess reserves rate and the reverse repurchase agreement rate. The interest on reserves (IOR) is a rate the Fed directly controls, where the Fed pays interest to banks that keep excess reserves at the Fed. The Fed’s control of interest on excess reserves gives the Fed ability to control interest rates even if there are abundant reserves in the market. By raising the interest on reserves rate, the Fed could counter inflationary pressures by increasing the opportunity cost of lending, which would incentivize financial institutions to keep their excess reserves risk free at the Fed.

Another short-term interest rate setting program is the reverse repurchase facility (RRP), which is an open market operation where the Fed sells a security with an agreement to repurchase the security at a specific time in the future at a certain price. The difference between the repurchase price and the sale price, including the length of time between the transactions, implies a rate of interest paid by the Fed on the cash invested by the counterparty institution. The RRP “interest rate” basically sets a floor on the short-term interest rate, since no market participant would be willing to lend under the risk-free rate provided by the Fed. In order to counter inflationary pressures, the Fed could increase the price of the repurchase, which would increase the opportunity cost of lending with an interest rate near or at the RRP interest rate.

Unlike the federal funds rate, the Fed can do reverse repurchase agreements with non-banks, which extends the Fed’s control to a broader set of market participants.  Therefore, the Fed will have access to over 140 financial institution and counterparties including corporations like Fannie Mae and Freddie Mac. One positive implication of this plan is that the Federal Open Markets Commission would have the ability to control financial conditions by directly setting the short-term interest rates. This would increase the Fed’s flexibility, since it could adjust its balance sheet to achieve its own economic objectives without having to be as concerned about the consequences of liquidity and indirect interest rate impacts like the Federal Funds Rate.

The Fed should use the reverse repurchase facility as its policy instrument and it should maintain the interest rate paid on bank reserves at the same level of interest. The Fed would be able to leave a large amount of liquidity in the system on a permanent basis, which should reduce risk and increase the market’s financial efficiency. Sack and Gagnon believe that the optimal solution would be achieved by setting the RRP rate in concomitance with the IOR rate. This would hopefully give the Fed sufficient control over short-term interest rates and also allow the Fed to influence broader market conditions in order to foster maximum sustainable output and stable prices.

The research on this policy is very new, and the Fed will need to complete more research on the effectiveness of using these two new tools in synchrony with each other. In the future, the Fed might no longer use the federal funds rate as its main policy tool, and the interest on excess reserves and reverse repurchase facilities could be the future determinants of United States monetary policy.