US economy

Time for Fed funds rate to make way for Sofr


The Federal funds target rate is the most important interest rate in the world. By setting a target interest rate for funds cleared through the Federal Reserve system, policymakers set monetary policy for the US economy and the world.

But the time has come for the Federal Open Market Committee to adopt a different rate target through which to express its monetary policy.

There are two reasons why the Fed funds target should be replaced. The first is the increasing obsolescence of the rate itself. The second is tied up with the Libor (London interbank offered rate) scandal, and policymakers’ response to it.

During the past decade the efficacy of the Fed funds target has waned. Fed funds is no longer a high-volume wholesale market. The vast volumes of liquidity created by quantitative easing mean many of the depositary institutions that used to borrow via the Fed system no longer need to. The Fed funds market has therefore shrunk in size and become increasingly the preserve of a small number of institutions, unrepresentative of the total financial system.

Nor are Fed funds volumes likely to recover soon. Although the Fed’s balance sheet reduction will eventually remove the excess liquidity from the system, the structure of the US interbank market has changed: overwhelmingly, banks now lend to each other using secured lending rather than the unsecured Fed funds market.

Successful implementation of monetary policy works by setting an interest rate that is a benchmark and effective driver of the interest rates on the multitude of wholesale and retail loans that make up the money market. As Fed funds volumes have declined, the Fed funds rate increasingly fails to meet this definition.

So although the FOMC can choose to maintain the fiction that it is targeting the Fed funds rate, to do so would merely be an unnecessary obfuscation of the Fed’s true policy target.

The second reason for the Fed to abandon a Fed funds target is more positive.

In the wake of the Libor scandal, the Fed has been at the forefront of the drive to replace this benchmark with new reference rates that are more rooted in actual transactions, and so are less reliant on “expert opinion” and less susceptible to potential manipulation. Such a move, it is felt, reduces the kind of systemic risk that resulted from markets’ loss of confidence in Libor a decade ago.

After an extensive consultation, the Fed-sponsored Alternative Reference Rates Committee selected a new reference rate, the secured overnight financing rate (Sofr).

Sofr’s benefits as a reference rate include high transaction volumes (about $800bn per day on average for the past three years — over 10 times more than current Fed funds volumes) and a wide range of market participants, including banks, broker-dealers and money-market funds.

The Fed wants Sofr to succeed: the ARRC has published an extensive “paced transition plan” to encourage swap market participants to switch to Sofr as a reference rate, including encouraging futures exchanges to quote Sofr futures and to phase-in technical changes embedding Sofr (for example, making Sofr the discount rate for margin calculations and the like).

But the biggest obstacle to Sofr succeeding as a new reference rate is the incumbency of other rates, including Libor and the Fed funds rate, which are referenced by trillions of dollars of financial instruments. Here, the FOMC can make a dramatic difference.

For the FOMC to switch its target rate from Fed funds to Sofr would surely require much public explanation. But if it chose to do so, not only would it have a more meaningful benchmark rate for the US economy, but it would be a powerful catalyst to introducing a more robust reference rate for US financial markets.

Laurence Mutkin is global head of G10 rates strategy at BNP Paribas



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