Dallas Federal Reserve President Lorie Logan has stated that the time has come for the U.S. central bank to consider shifting away from its long-standing benchmark, the federal funds rate. In a recent speech, Logan argued that significant changes in financial markets since the 1990s have made the current target outdated and potentially fragile.
Her proposal suggests a fundamental review of how the Federal Reserve implements monetary policy, aiming to ensure its tools remain effective in a modernized financial system. The move would represent a major technical adjustment to the Fed's operational framework.
Key Takeaways
- Dallas Fed President Lorie Logan advocates for preparing a new benchmark interest rate to replace the federal funds rate.
- Logan argues that money markets have evolved significantly, making the current fed funds target outdated.
- She warns the connection between the fed funds rate and broader monetary conditions is "fragile" and could break suddenly.
- The proposal is framed as a necessary technical modernization, consistent with the Fed's history of adapting its policy tools.
A Proposal to Modernize Fed Policy
In prepared remarks for a monetary policy workshop, Dallas Fed President Lorie Logan presented a case for updating the Federal Open Market Committee's (FOMC) primary policy instrument. For decades, the FOMC has used the target range for the federal funds rate to adjust the stance of monetary policy.
The federal funds rate is the interest rate at which commercial banks lend reserve balances to other depository institutions overnight. It has been the central focus of Fed policy announcements since the committee began issuing post-meeting statements in the mid-1990s.
Logan emphasized that this call for change is a technical matter, not a shift in the overall goals of monetary policy. "Modernizing our rate control system is technical in nature," she stated, highlighting the need to maintain effective control over financial conditions on behalf of the public.
What is the Federal Funds Rate?
The federal funds rate is a crucial interest rate in the U.S. economy. It influences other borrowing costs, including rates for mortgages, credit cards, and business loans. By setting a target for this rate, the Fed aims to manage inflation and support maximum employment.
Evolving Financial Markets Weaken Old Tools
A core part of Logan's argument is that the financial landscape has transformed dramatically since the federal funds rate was established as the primary public target. She noted that money markets today look very different from how they did nearly 30 years ago.
The volume of transactions in the federal funds market has diminished relative to other short-term borrowing markets. This means the rate is based on a smaller and potentially less representative segment of the financial system than it once was.
This evolution raises questions about whether the fed funds rate is still the most appropriate benchmark for the Fed to target. Logan pointed out that the central bank has a history of adapting its operational targets as the financial system changes to ensure its influence remains robust.
"The Fed has evolved its operating targets through the years to maintain influence over monetary conditions as the financial system evolved. Updating the target from time to time is part of how we manage the central bank efficiently and effectively on the public’s behalf."
The Fragility of the Current System
While Logan acknowledged that targeting the federal funds rate currently provides effective control, she issued a stark warning about the stability of this mechanism. She described the connections between the fed funds rate and broader monetary conditions as "fragile and could break suddenly."
This fragility poses a significant risk. If the link were to weaken unexpectedly, the Federal Reserve's primary tool for steering the economy could become less effective, potentially complicating its response during a period of economic stress.
By preparing for a new benchmark rate now, Logan argued, the FOMC could proactively mitigate this risk. "The FOMC should take that risk off the table," she urged, suggesting that a more robust and relevant benchmark is needed for long-term stability.
Historical Context of Fed Targets
The Federal Reserve has not always targeted the federal funds rate. In its earlier history, it focused on other metrics, such as bank reserves or monetary aggregates like M1 and M2. The shift to publicly targeting the fed funds rate in the 1990s was itself an evolution in response to a changing economic environment.
What a New Benchmark Could Mean
Logan did not specify which interest rate should replace the federal funds rate, but her comments open a significant debate within the central bank. Potential candidates could include rates that are based on a larger volume of transactions, such as the Secured Overnight Financing Rate (SOFR).
SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. It is already being widely adopted as a replacement for the London Interbank Offered Rate (LIBOR) in financial contracts.
Key Differences in Potential Benchmarks
- Federal Funds Rate: Based on unsecured overnight lending between banks.
- Secured Overnight Financing Rate (SOFR): Based on secured overnight loans collateralized by U.S. Treasury securities, representing a much larger market volume.
A shift to a new benchmark would be a complex, multi-year process involving careful planning and communication to ensure a smooth transition for financial markets. However, Logan's speech indicates that high-level discussions about the future of the Fed's operational framework are now underway.
The ultimate goal of such a change would be to enhance the Fed's ability to implement its policy decisions effectively, ensuring that its actions translate reliably into the desired conditions for the broader U.S. economy.
