Dallas Fed President Lorie Logan recently proposed ditching the federal funds rate target as the Fed’s main policy tool. Her proposal would ensure that the Fed can continue to effectively implement monetary policy, but it fails to address one of the main flaws of the post-2008 monetary system.
The Fed’s Operating Target
In order to explore the merits of Logan’s argument, it helps to consider the context of what the Fed tries to do and how it tries to do it. The Fed’s job is to achieve maximum employment and price stability. To do that, it influences borrowing costs across the economy. Everything from mortgage rates to credit card APRs is affected by Fed policy. But it can’t set those rates directly. Instead, it tosses a small pebble into the financial pond—a change in its operating target—and counts on ripples through the financial system to spread outward towards its macroeconomic objectives.
Throughout its history, the Fed has used different pebbles to start those ripples: the quantity of bank reserves, the money supply, and, since the mid-1990s, the federal funds rate – the overnight rate on money that banks lend to each other.
Before 2008, targeting the federal funds rate worked smoothly. The Fed hit its target by adjusting the supply of money in the banking system. When banks were short on money, they would look to make up the shortfall in the federal funds market. Reducing the federal funds rate target made it cheaper for banks to obtain funds, which allowed them to pass lower rates on via their own lending. The ripples eventually reached households and businesses through cheaper loans and easier credit, stimulating spending and investment.
At the moment, adjusting the federal funds rate still produces the Fed’s desired ripple effect. But Logan is raising the alarm: it might be time to reach for a new pebble.
A Fragile Link
Before the Global Financial Crisis, the federal funds market was vibrant. Banks with excess reserves lent to those with shortfalls. The interest rate on those overnight loans is what we call the federal funds rate.
The financial landscape changed dramatically after the crisis. The Fed flooded the banking system with money through quantitative easing and began paying banks interest on the funds held on deposit at the Fed. Suddenly, money in the banking system was no longer scarce, and banks had little need to borrow from one another. With trillions of dollars now sloshing through the system, both borrowers and lenders largely disappeared.
The market didn’t vanish entirely. A few players, most notably the Federal Home Loan Banks (FHLBs), continue lending because they cannot earn interest on their balances at the Fed. On the demand side, foreign bank branches in the US stepped in to exploit small arbitrage opportunities between the federal funds rate and the Fed’s interest on reserves.
That narrow participation keeps the market alive, but only barely. It now sees about $100 billion in daily volume, compared to trillions of dollars in secured repo markets. As Logan warns, with so few participants, the connection between the federal funds rate and broader money markets is fragile. If the FHLBs were to pull back—say, during a crisis like the Silicon Valley Bank episode in 2023—the market could dry up.
And, if that happens, the Fed could toss its pebble into the pond…and find that no ripples follow.
A New Pebble?
What should replace the federal funds rate? Logan argues that the Fed should consider targeting a Treasury repo rate, such as the tri-party general collateral rate (TGCR).
Repo markets are where borrowers obtain short-term funding by pledging high-quality assets, like Treasury securities, as collateral. Logan describes a number of advantages in moving to a Treasury repo rate target. The most obvious is the size and breadth of the market. TGCR transactions account for more than $1 trillion in daily volume across a broad set of financial institutions. This makes it unlikely to be affected by the behavior of individual institutions, which stands in sharp contrast to the influence of the FHLBs in the federal funds market.
There is also a strong link to other money markets. Since TGCR represents the marginal cost of funds for a meaningful segment of the financial system, changes to it will almost certainly pass through to other short-term interest rates. This again stands in contrast to the federal funds rate, which primarily results from the arbitrage activities of a small number of foreign banks. The possibility of throwing a TGCR pebble and not getting the desired ripple effect is slim.
Notably, the Fed is already trying to influence repo markets by encouraging use of its Standing Repo Facility (SRF). The SRF is designed to keep market repo rates – like the TGCR – in sync with the federal funds rate. Financial institutions appear hesitant to use the SRF. Targeting TGCR directly would be a more straightforward path to achieving the Fed’s goals.
From Pond to Pool
Logan’s proposal addresses a legitimate concern – the fragility of the federal funds rate – but it doubles down on a bigger problem with the post-2008 monetary system: the financial pond has been transformed into a Fed-controlled pool.
Prior to 2008, the contours of the financial pond were largely determined by market forces. The Fed would toss its pebble in, and the desired ripples would be produced by its interaction with the supply and demand for money in the banking system. In other words, the Fed could control the federal funds rate, but it had to account for existing market conditions to achieve its target range.
After 2008, the Fed massively increased the amount of money in the banking system, to the point where banks no longer borrow and lend to each other. Under this system, the federal funds rate ceases to be a market-clearing price reflecting supply and demand – instead, it becomes a fixed price arbitrarily set by Fed decision makers. The price signals that result from banks trading funds with one another are suppressed, and the Fed becomes the dominant supplier of short-term funding. The financial pond is transformed into a pool requiring the Fed’s regular maintenance.
Logan advocates keeping the current system – that is, keeping a large supply of money in the banking system – even after moving to a repo operating target. This is where her proposal runs into trouble. Maintaining the Fed’s outsized role in the financial system weakens market mechanisms that help to allocate credit efficiently and discipline bank risk-taking. It also raises political concerns: the more interaction the Fed has with the financial system, the greater scope it has for influencing credit allocation and picking “winners” and “losers”.
In contrast to Logan’s proposal, two other Fed officials – Governor Michelle Bowman and Kansas City Fed President Jeffrey Schmid – have recently advocated shrinking the Fed’s role in the financial system. In a November 13 speech, Schmid noted this could “promote a more efficient allocation of liquidity, an allocation influenced by price signals and market forces.”
Treasury Secretary Scott Bessent has made similar critiques of the Fed’s current framework.
Conclusion
Reducing the Fed’s role in the financial system – letting the pool evolve back into a pond, with market forces directing the ebb-and-flow – would be a step in the right direction. This evolution will take time, though.
Logan’s proposal has the virtue of highlighting that the link between the federal funds rate and the broader financial system may break down before that evolution is complete. A well-rounded reform should address both issues – finding an effective, new pebble while also facilitating the evolution back towards a pond.
