In our first blog post this week, we discussed the reason behind the drift higher in the effective federal funds rate (EFFR) within the Fed’s target range. So far, the Fed’s technical adjustment at the June FOMC (described in our earlier blog) as well as the passing of quarter-end (a time when banks can often become constrained) have appeared to contain the recent upward drift. But what if the EFFR continues to move higher as the balance sheet run-off progresses?
In this blog, we will highlight two solutions to control the short-term policy rate that are being discussed in the marketplace and three additional proposals. Our view on the preferred solution is predicated on our assumption that the level of excess reserves in the banking system is not yet at frictional levels. Instead, the current regulatory framework and the Fed’s approach are constraining the flow of dollars within the domestic system causing reserves to be trapped. As we discussed in our last blog, the domestic dollar funding market is bifurcated between the reserve rich global systemically important banks (G-SIBs) and the deposit poor small regional banks which is creating the illusion of a scarcity of reserves which is really the result of a distribution problem of reserves among banks.
Reflecting back on these five solutions, without the ability to change the current regulatory framework (which would be the most ideal scenario), we favor number three for its simplicity. The primary benefits of dropping IOER and moving the RRP to the mid-point of the target range for the fed funds rate are: 1) encourages the economic use of excess reserves for lending 2) allows the Fed and the market to discover the “true” level of reserves needed within the banking system and 3) quantifies the appropriate cost of short-term dollar funding.
We are nearing an important inflection point for the operational soundness of monetary policy at the Fed as the balance sheet run-off continues. Ultimately, the Fed’s playbook will be one that others with large balance sheets will follow. Money markets are adapting to the new regime but need more clarity rather than more FOMC rates. Simpler is better. There is much uncertainty about the appropriate level of reserves needed to allow healthy banking system functioning, avoid overheating assets and remove the potential for a policy error. The ambiguity provided by the Fed’s current approach, in a world where more technical adjustments may ultimately be needed, will only add to financial market volatility at a time when central banks globally are tightening policy.