(Bloomberg) — Debate on the change of the key interest rate of the Federal Reserve System began.
In the face of declining volumes and dominance of the federal funding rates of several participants in the market, the Central Bank began discussing a potential alternative to the benchmark, while trying to strengthen control over the short-term interest rates in the country.
Although this topic stepped to thebackground in the recent weeks amid the discussions about the shift in the FRS’s tightening trajectory and the fate of the regulator’s balance of $4.1trillion, the discussion’s outcome may have dramatic influence for thefinancial markets. At the last month’s meeting, FRS Open Market Committeemembers proposed two potential alternatives that could hardly differ more. However,some strategists say that the change in direction of the monetary policy mayhappen next year.
“FRS knows the federal funding rate has drawbacks, – the head of the US interest rate strategy at Bank of America Corp. Mark Cabana said. – Probably, it seems as hopelessly rotten to them and the market.”
Interbank credit market
For many, the federal funding rate is a synonym of the central bank’s target rate; however this term is much more comprehensive. It is a market where financial companies provide overnight loans from reserves held on deposits of the New York Federal Reserve Bank — formally to ensure they comply with the critical requirements for overnight reserves.
To control the federal funding effective rate and the rates of the wider money market, respectively, before the financial crisis, FRS used open market transactions to manage the deficit of reserves available for lending on a specific day. However, the market dynamics changed when the quantitative easing measures aimed at support of the economy led to creation of new large reserves at banks, which reduced the need to attract the interbank credits.
The changes introduced at that time allowed the market to remain unaffected. The new laws gave FRS the right to pay the interest for excess reserves remaining at central bank accounts to some participants. Those who did not receive this privilege began to provide loans below the rate paid by FRS (IOER) and created an attractive arbitration opportunity for certain companies that could borrow at the rate which was close to the effective federal funding rate and then place the funds at New York FRS at IOER rate. $
As FRS balance reduced the liquidity in the financial system began to melt away and many market participants suggest that the bank reserves volume may be insufficient again. In addition, the surge in treasury notes and the corresponding increase in profitability pushed up the other key short-term rates, especially in the repo market.
In these conditions, it became more profitable to place reserves not at the interbank, which exerted an upward pressure on the federal funding rate.
In this quarter, the daily turnover, which used to amount to hundreds of billions of dollars, fell to the average value of $64 billion, according to data of the New York FRS. As a result, a group of the state-sponsored mortgages became dominant in the market, having unintentionally received excessive influence on the federal funding rates.
OBFR or SOFR
At the meeting on November 7-8, representatives of the regulator proposed to target not the federal funding rate, but the one-day bank funding rate (OBFR).
In addition to daily transactions with the federal funding rates, this unsecured lending benchmark, published by the New York FRS, takes into account transactions with euro and dollar, mainly reflecting the borrowing of banks from non-bank financial institutions, including the money market mutual funds, thanks to which the daily turnover almost doubles.
FRS meeting participants noted that the similarity of OBFR and the federal funding rates is likely to mean that there will be no major changes in the monetary policy management if the central bank chooses targeting of this rate. However, some members of the discussion would like to analyze the possibility of applying a secured lending rate, paving the way for the SOFR that has been introduced by the New York FRS earlier this year.
Сокращенный перевод статьи: The Death of Fed Funds? As Market Dries Up, FOMC Asks What Next