The FOMC minutes released last week indicate that the Fed may overhaul its monetary policy benchmark rate – the federal funds rate. There’s been a problem with trading volume in the fed funds market for some time. The general explanation is that since the introduction of the IOER (Interest On Excess Reserves), cash has moved out of the fed funds market and into the Fed. I would take it one step further. The main problem with the fed funds rate is that banking doesn’t represent all of the financial intermediation in the economy anymore. Much of that intermediation occurs through the Repo market, making Repo a more important overnight interest rate. But instead of scrapping the fed funds rate altogether, the idea is to redefine it. According to the Fed, “the federal funds rate should continue to play a role”* The question is: how do you redefine something that’s, well, already defined?

The Problem With Fed Funds

The fed funds market is an overnight market for non-collateralized bank lending. Participants include banks, thrifts and the GSEs. The size of the market has shrunk considerably since the beginning of the financial crisis – from trading around $200 billion a day in 2007 to about $60 billion a day in 2012 and down to $40 billion recently. One reason for the dramatic drop in volume is the IOER. When the Fed started paying an above market rate for excess bank reserves, cash naturally moved straight into the Fed. However, not all fed funds market participants have access to the Fed. The Federal Home Loan Banks (FHLBs) are left out and stuck in the fed funds market, while the other banking institutions can deposit cash directly at the Fed. That leaves the cash lending side of the market dominated by the FHLBs and the borrowing side dominated by foreign banks. Shockingly, much of the foreign bank volume is attributed to the arbitrage between the fed funds market and the IOER – borrowing cash in the funds market and depositing it at the Fed; earning a spread in the process.

New Definition

What the Fed wants to do is examine “the possibilities for changing the calculation of the effective federal funds rate in order to obtain a more robust measure of overnight bank funding rates” That is, they want to take into account a wider range of loans between banks. They’re basically three types of overnight bank loans – fed funds (domestic), LIBOR (foreign), and Repo – technically a different market but with bank participants. LIBOR – also called eurodollars – are dollar deposits held outside of the U.S. Those deposits can be anywhere: the Caribbean, Europe, Asia, etc.

The Fed Funds Effective Rate

It’s interesting that the FOMC specifically mentioned “effective federal funds rate.” The effective rate is the weighted average of overnight fed funds traded through the inter-dealer brokers. So the implication is clear, the FOMC wants to add an overnight LIBOR rate to the effective fed funds rate, generating a combined U.S. and foreign lending rate between banks. There are two issues here: First, the problem with combining a weighted average with a survey. Second, that the Fed might consider foreign interest rates for U.S. monetary policy.

The Pros And Cons

The U.S. dollar is a global currency and interest rates in foreign markets effect those in the U.S. So clearly, foreign U.S. dollar rates affect U.S. domestic rates. Also, the federal funds rate is the benchmark that’s been used for years, so it might be confusing for the market to change the benchmark rate just when the Fed is about to undertake a round of tightening with a large balance sheet. That could add uncertainly and unnecessary volatility to an already complicated process. Both good reasons to keep using fed funds.

On the other hand, there are some problems. Many U.S. banks take deposits from U.S. customers and book them in a Caribbean branch to avoid regulation. Including these transactions in the fed funds market would make some sense – even though many of these “customers” aren’t necessarily banks. But where do you draw the line? What markets for overnight bank funding transactions are relevant for the new definition of fed funds? It’s like having a bad football team that’s losing all the time and then adding more bad players to the team. It doesn’t make a winning team.

If the Fed chooses to use a broader definition, the next stop is overnight LIBOR, which is calculated by surveying banks. Remember the LIBOR scandal? Banks rigged LIBOR in order to make money for their own trading books. [For the inside story on the LIBOR rate rigging scandal, see my book Rogue Traders.] It would be very surprising if the Fed chose to base U.S. monetary policy on a rate that was being manipulated only a few years ago. Granted, the overnight rate was never manipulated and the survey was recently reformed, so we can assume the survey system is legitimate now. However, the benchmark rate used for monetary policy in the U.S. should be “anchored” by observable transactions. It’s also true that some of the inter-dealer brokers arrange trades in overnight eurodollars, but again, where do you draw the line? Manipulation aside, there’s still a problem with calculating a global fed funds effective rate – the domestic portion is a weighted average and the international portion is a survey.

Then, there’s the philosophical question of whether the Fed should target foreign inter-bank lending rates, Caribbean locations aside. Should the Fed be managing dollar interest rates in other countries? Yes, rates are connected and the the Fed should be conscience of dollar funding levels outside of the U.S. But aren’t the other central banks responsible for the monetary environment within their own countries? I see using LIBOR rates as crossing a line, a new responsibility for dollar rates in foreign countries.

Think of this – normally the overnight eurodollar and overnight fed funds rates trade at about the same level. However, during a financial crisis, LIBOR and eurodollar rates spike relatively higher. A higher effective fed funds rate would mean the Fed injects more liquidity in the U.S. market to make up for lack of liquidity in foreign markets, thus making U.S. overnight rates relatively too low during a crisis than the domestic U.S. monetary landscape warrants.

The Repo Rate Is No Longer In The Running

Earlier this year, we heard chatter and speculation that the Fed might replace the fed funds rate when it comes time to tighten. Fed Chair Janet Yellen said on February 27th that the Fed is considering a Repo rate to replace fed funds because such a change would give the Fed more control over short-term rates. Even Dallas Fed President Richard Fisher commented, “It is my opinion that the fed funds rate is not the right tool going forward.” A Repo rate is clearly better than fed funds. There’s been a decline in fed funds volume over the years for a reason. It’s just not as important anymore. The Repo market is a $4.5 trillion a day market and represents funding rates in both the banking system and the shadow banking system – the entire financial system. But that all changed last week with the release of the FOMC minutes. It appears Repo is no longer in the running.

* FOMC Minutes; June 17-18

** Financial Times; “Policymakers weigh benchmark rate rethink” and “US weighs makeover for Fed [sic] funds rate”; July 11, 2014; Pages 1, 3