Joe Abate on the Fed's Interest Rate Mechanics and the Price of Liquidity

Evolving Fed Rate Targeting Mechanics

• 🎯 The Federal Reserve traditionally targets the Fed funds rate, but the mechanics of how it achieves this target have evolved significantly.
• 🏦 Originally, the Fed operated under a scarce reserve regime, where it kept liquidity slightly below banks' desired levels to create torque in the interbank market and precisely control the Fed funds rate.
• 💡 Post-2008, the Fed shifted to an ample reserve regime, supplying abundant reserves, which fundamentally changed the Fed funds market and led banks to reduce interbank borrowing.

The Shift from Fed Funds Target

• 🗣️ Dallas Fed President Lorie Logan has proposed moving away from targeting the Fed funds rate, suggesting alternatives like the triparty repo rate.
• 🔍 The Fed funds market has become less active, primarily serving as a communications device rather than a true market for borrowing reserves.
• 📊 A market-traded instrument like the triparty repo rate could provide a better feedback mechanism on the Fed's liquidity management and policy effectiveness.

Rationale for Balance Sheet Efficiency

• 💰 While ample reserves can enhance bank safety, an inefficiently large balance sheet can lead to distortions.
• 🏦 Over-supplied reserves can incentivize banks to hold excessive cash, potentially crowding out other assets like loans and making them more susceptible to rate sensitivity.
• 📉 During QE, bloated balance sheets contributed to weak loan demand and a buildup of rate-sensitive deposits, which became volatile when rates rose.

Triparty Repo vs. SOFR

• 🧩 The triparty repo rate is favored as it reflects a pure financing market where dealers raise cash from providers like money market funds.
• ⚖️ SOFR (Secured Overnight Financing Rate) is broader, including the bilateral repo market, which can lead to bifurcated equilibria and less clear signals.
• 📈 Logan's proposal aims for a single, active market-traded rate to better gauge liquidity and policy transmission.

The Rising Price of Liquidity

• 📉 Despite reserves remaining ample, their price is increasing due to factors like Quantitative Tightening (QT) and the Treasury's increased cash balance.
• 🏦 As the Fed's balance sheet shrinks, reserves are drawn down, disproportionately affecting foreign banks which are active traders in the Fed funds market.
• ⚡ This reduction in liquidity and bargaining power for foreign banks leads to a higher cost of liquidity for them.

Stablecoins and Swap Spreads

• 💳 Stablecoins could theoretically act as new buyers for Treasury bills, supporting Treasury issuance without raising rates, but they may substitute for other payment methods like deposits.
• 🌐 Demand for payment tokens might be higher outside the US, serving as a substitute for currency in underbanked economies or for remittances.
• 📈 Swap spreads are widening globally, reflecting a general concern about increasing government debt and the demand for a premium to hold it, indicating a realization of unsustainable fiscal policy directions.