Revisiting the Operating Target

At each FOMC meeting, a target policy rate is announced, called the fed funds target range. This 25 basis point-wide corridor is referred to as the Federal Reserve’s “operating target range.” The operating target itself is separate from (but related to) the FOMC’s decisions on how tight or loose monetary conditions should be. Once the target range is set, the FOMC uses various facilities to maintain overnight interest rates within this band by helping set ceilings and floors for each market participant. The floor is anchored by the Reverse Repurchase Agreement (RRP) rate for non-bank institutions and the Interest on Reserve Balances (IORB) rate for deposit-holding institutions. The ceiling is the Standing Repo Facility (SRF), which allows primary dealers and deposit institutions to borrow cash at the top end of the corridor. To judge the effectiveness of this range in transmitting monetary policy, the FOMC uses the effective federal funds rate (EFFR) as a market benchmark.

Developments in the funding markets over the years have minimized the relevance of the federal funds market and expanded the relevance of the Treasury repurchase agreement (repo) market. This shift was by design, as the Federal Reserve and other regulators encouraged more secured borrowing in the Treasury and Government Agency repo markets. This trend is evident in the volume data of these markets: Treasury repo volumes have seen steady growth, while unsecured markets have flatlined (Figure 1). Hence, Logan and others have called for modernization of the Fed’s benchmark rate to measure the effectiveness of the target range and better reflect current funding market conditions.

Although fed funds remain a viable gauge for a subset of money market funding conditions, evidence is growing that its effectiveness as a temperature check for broader money market rates is weakening. For instance, in Figure 2, we see that TGCR (Tri-Party General Collateral Rate, blue line) has recently traded in a wide range within the target band, while EFFR (light green line) has remained mostly static. The relative stability of EFFR is potentially misleading, since the Fed’s goal is to broadly maintain overnight borrowing rates within its target range. While that is true when measured by EFFR, other recent measures of short-term funding rates (TGCR) have drifted outside the preferred range. This dynamic could potentially overstate the effectiveness of the Fed’s rate control mechanisms, particularly if the link between fed funds and other front-end rate measures continues to weaken.

Proposed Alternatives

Logan explored three broad categories of potential alternatives to EFFR in her recent speech:

• Administered Rates: Such as the Reverse Repurchase Agreement (RRP) and the Interest on Reserve Balances (IORB).
• “Constellation” of Rates: A basket of rates that would, in the aggregate, measure the performance of the target range policy.
• Single Market Rates: Such as the Secured Overnight Financing Rate (SOFR) or the Tri-Party General Collateral Rate (TGCR).

Logan prefers a single market rate, arguing that the other two alternative measurement categories have drawbacks. An administered rate is simply a Fed-determined level and does not capture market dynamics. A basket of rates muddies the waters and makes it difficult for the Fed to communicate which rate is most relevant (or not) at a given point in time. A single rate is clean, straightforward, and easy to align with the Fed’s target range.

From the single rate options, Logan favors TGCR, as it has high volumes, a wide set of participants, and avoids some of the noise embedded in SOFR. TGCR can be viewed as (primarily) the rate that money market funds (MMFs) earn on their cash in the repo market and, conversely, the rate of funding that large broker/dealers pay to finance their repo books. In this market, both parties are generally on equal footing, meaning the negotiation over rates is competitive, with neither side able to easily impose terms, thanks to a broad set of participants and alternatives.

SOFR, on the other hand, includes an embedded market premium in its calculation. This premium arises because, in some segments of the repo market, large dealers have more market pricing power: they can charge higher borrowing costs to clients who have limited options for obtaining leverage and who may face a more restricted set of counterparties in the repo market. As a result, SOFR can reflect these higher costs, making it less representative of the true cost to borrow cash in a competitive market. Since TGCR avoids capturing this premium, it is well-positioned to provide a clean and robust measure of the cost to borrow cash.

Why Now?

Beyond the argument that the Fed should update and modernize its target benchmark rate to better reflect the modern secured borrowing era, the question remains: why now? This argument could have been made years ago, as transaction volumes for federal funds have been well-below secured borrowing for over half a decade.

One explanation for the timing may revolve around the current phase of the Fed’s balance sheet normalization process. Recently, over $2 trillion in funding market liquidity was placed daily in the Fed’s Reverse Repurchase Agreement facility (RRP); now, that figure stands below $100 billion. The higher balances reflected a period when cash and bank reserves were abundant in the financial system, resulting in high usage of the RRP facility and anemic overnight funding rates in the market that were frequently pinned to the lower bound. In June 2022, the Fed began quantitative tightening (QT), shrinking bank reserves with the goal of normalizing its balance sheet. As reserves have transitioned from “abundant” to “ample” and the Fed’s RRP facility usage has essentially reached zero, overnight rates have risen off the floor as supply and demand have come into better balance.

This backdrop has brought into focus the growing disconnect between EFFR and repo market rates, which is becoming increasingly difficult to ignore. For example, in the past month, the spread between EFFR and TGCR has widened to ~5 basis points, showcasing how QT is manifesting in the front-end as overnight rates awaken from a years-long slumber (see Figure 3). We are still in the early stages of this shift, and the spread has only recently widened noticeably. However, this moment has been building for years, and successfully managing this transition in reserves is a key goal for the Fed.

By selecting a target rate that better reflects the true cost of funds, the Fed gains better insight into front-end rates and can act more effectively if funding pressures arise -- pressures that might otherwise be masked by the limitations of the fed funds market. The Fed has a window of opportunity, while reserves are still abundant, to modernize the target rate and better equip itself to achieve balance sheet normalization in an orderly way. The combination of a relatively calm funding market, QT running in the background, and RRP draining to essentially zero provides the right backdrop for this discussion to gain traction. The recent emergence of increased repo volatility serves to highlight the issue and supports the case for re-examining the framework in the near-term. 

Acronym Glossary:

EFFR – Effective Federal Funds Rate
OBFR – Overnight Bank Funding Rate
SOFR – Secured Overnight Financing Rate
TGCR – Tri-Party General Collateral Rate
BGCR – Broad General Collateral Rate
RRP – Reverse Repurchase Agreement
IORB – Interest on Reserve Balances
SRF – Standing Repo Facility
FOMC – Federal Open Market Committee
QT – Quantitative Tightening
MMF – Money Market Fund