On the eve of the liquidity storm, intense debate within the Federal Reserve: Should the benchmark interest rate be changed?

According to Zhitong Finance APP, as the excess liquidity in the U.S. financial system continues to shrink over the coming months, discussions on how to assess the tightness of money supply and what benchmark interest rate the Federal Reserve should anchor have reignited.

Several individuals, including Cleveland Fed President Loretta Mester, JP Morgan analyst Teresa Ho, and Wrightson ICAP Chief Economist Lou Crandall, have pointed out the limitations of the federal funds rate, with some suggesting that the Federal Reserve should abandon this indicator and instead use other tools to measure money supply.

Once, the federal funds market, as an important channel for overnight interbank lending, could sensitively reflect signals of tightening financing conditions. However, large-scale monetary stimulus during the financial crisis and the pandemic led to a flood of dollars in the U.S. banking system, prompting banks to withdraw from the federal funds market and deposit funds directly with the Federal Reserve.

Currently, the average daily trading volume in this market is about $110 billion (only 0.5% of commercial banks' assets, far below the 2% level before 2008), with the main lenders being Federal Home Loan Banks and the borrowers primarily foreign institutions. In contrast, the average daily trading volume of repurchase agreements collateralized by Treasury securities reaches several trillion dollars, becoming the pricing basis for benchmark rates such as the Secured Overnight Financing Rate (SOFR).

"We really need to reflect on how relevant the federal funds rate is, and how relevant some other rates are," said Cleveland Fed President Loretta Mester at an event in April.

By July, with the U.S. Congress raising the debt ceiling by $5 trillion, coupled with the Treasury potentially issuing more short-term Treasury bonds and the Federal Reserve's balance sheet reduction creating a cumulative effect, concerns about fluctuations in the financing environment have made this issue more pressing.

This benchmark interest rate, in use since the 1980s, is seen as a tool for the Federal Reserve to regulate the flow of credit in the economy. However, the real regulatory levers have now shifted to a series of administered rates directly set by the Federal Reserve, including the Interest on Reserve Balances (IORB). Although the federal funds rate is theoretically supposed to fluctuate within a target range of 25 basis points, it has remained almost unchanged over the past two years, aside from adjustments to policy rates—holding steady at 4.33% as of July 23. In contrast, indicators such as the overnight general collateral repurchase agreement rate have shown significant volatility, suggesting that the repo market may better reflect the flow of funds.

Crandall from Wrightson ICAP stated, "The federal funds rate is no longer at the core of the dynamics of the money market as it was in past decades."

Due to its sluggish response to changes in liquidity, there are concerns that it may not provide early warnings of potential pressures. Teresa Ho, head of U.S. short-term interest rate strategy at JP Morgan, stated, "Focusing on the federal funds rate is unreasonable because Federal Home Loan Banks are not the true liquidity providers in the market. There are many other participants in the market who largely determine liquidity demand." "I still believe that the federal funds rate is not a good indicator of liquidity."

However, controversy remains, with New York Fed economist Roberto Perli and Dallas Fed President Lorie Logan among those defending the current system.

The New York Fed, which plays a key role in withdrawing liquidity from the U.S. financial system and detecting early signs of market turmoil, declined to comment, only mentioning Perli's remarks about the rate.

Perli had previously stated that the federal funds rate is just one of many indicators, others include domestic borrowing and banks' intraday overdrafts. However, at an event in March, Perli acknowledged that the rate does not respond to daily changes in reserves and that there is evidence indicating increasing pressure in the repo market.

Financing Pressure

Market turbulence in financing is not uncommon. In 2019, when the Fed reduced its balance sheet to $1.5 trillion, a lack of awareness of the scarcity of bank reserves, combined with factors such as Treasury settlements and corporate tax payments, led to a spike in key rates and prompted central bank intervention. Currently, while bank reserves stand at $3.38 trillion, Fed Governor Christopher Waller recently hinted that they might be allowed to drop to $2.7 trillion.

Bank of America strategists warn that as the Treasury slows down the rebuilding of cash reserves, liquidity pressures may emerge in September: the usage of reverse repo tools (an excess liquidity indicator) may approach zero, coupled with mid-month tax payments and bond settlements exacerbating fund outflows. The latest Fed meeting minutes also confirmed this expectation.

Crandall from Wrightson believes that while a decline in reserves may not directly affect the federal funds rate, it cannot be ruled out that it may slowly rise within the current range. He advocates for using repo indicators such as the Tri-Party General Collateral Rate (TGCR), which is supervised by the New York Fed, as a more suitable alternative to the federal funds rate, as it better reflects real capital flows. A report from the "Group of Thirty," led by former New York Fed President William Dudley, suggested in May that the Federal Open Market Committee should stop publishing the target range for the federal funds rate and instead use the Interest on Reserve Balances (IORB) as a policy anchor.

Former Fed Vice Chairman Richard Clarida stated that the relative movements among a range of short-term rates are important. "I think the federal funds rate is not that important right now," Clarida said in an interview, "What matters is that all short-term rates can closely align."