Dallas Fed Paper Highlights Declining Impact of Federal Funds Rate Transmission

Recent research from the Federal Reserve Bank of Dallas indicates a need to reevaluate the interest rate that the Federal Reserve targets to meet its monetary policy objectives. A new paper by Sam Schulhofer-Wohl, a senior advisor to Dallas Fed president Lorie Logan, suggests that the tri-party general collateral rate (TGCR) may be a more effective tool than the federal funds rate.

Declining Impact of Federal Funds Rate

The paper, released on December 16, highlights that the influence of adjustments in the federal funds rate on broader borrowing costs has weakened. Schulhofer-Wohl noted that while this influence has not entirely dissipated, its efficacy has notably decreased in recent months. Conversely, the transmission of the TGCR has shown more stability, deteriorating less than the effective federal funds rate (EFFR) during recent economic conditions between 2018 and 2020.

Historical Context and Current Trends

The Federal Reserve has traditionally aimed to manage inflation and promote job growth by adjusting the federal funds rate, which serves as a benchmark for banks borrowing reserves from one another. However, large-scale bond purchases as part of monetary policy have flooded the financial system, diminishing the federal funds market’s relevance in comparison to other money market sectors.

• Fed’s Targeting Approach: Despite the federal funds rate’s reduced significance, the Fed has continued to target it due to its historical correlations with money market rates.
• Logan’s Caution: In a September speech, Lorie Logan warned that the current effectiveness of targeting the funds rate is fragile. She advised that the Federal Open Market Committee (FOMC) should reassess this approach.

The Case for TGCR

According to Logan, if the Fed were to shift its focus, the TGCR stands out as the best alternative. This is primarily because the TGCR market remains active, and the Fed’s existing tools allow for effective control over it. Any transition in the interest rate the Fed aims to influence is more technical and separate from broader discussions regarding the appropriate level of short-term borrowing costs.

The ongoing dialogue about redefining monetary targets highlights the importance of the Fed’s ability to reliably affect borrowing costs in order to fulfill its economic goals.