Lots More with Joe Abate on the Fed's New Target and the Rising Price of Money

Episode Summary

Executive Summary: Joe Abate explains how the Fed’s operating framework shifted from scarce to abundant reserves, why Fed funds is increasingly a communications benchmark rather than an active market, and why a market-based repo rate could better reveal liquidity conditions. The discussion also covers shrinking reserves, bank-balance-sheet effects, stablecoins as potential Treasury-bill buyers, and rising global concern about government debt and swap spreads.

Main Topics: How the Fed implements interest-rate policy: The Fed formerly used scarce reserves and active open-market operations to steer the Fed funds rate to a pinpoint target. Since around 2008, abundant reserves have made the market function differently, with the Fed setting a target range and influencing rates through administered rates. Fed funds as a policy signal and benchmark: With banks no longer needing to borrow reserves, Fed funds activity has narrowed largely to transactions between Federal Home Loan Banks and non-U.S. banks. Abate says the rate remains useful for communicating policy, but its limited activity may make it a less informative gauge of market liquidity. Potential shift toward a repo-rate target: Dallas Fed President Lori Logan has argued for considering alternatives to targeting Fed funds. Abate says a rate from an active repo market could provide both a policy signal and feedback on liquidity as the Fed reduces its balance sheet, although a change is not expected within the next two years. Declining reserves and liquidity costs: Quantitative tightening and the Treasury’s higher cash balance are drawing reserves from the system. Once the reverse repo facility has little remaining balance to absorb the decline, further balance-sheet runoff directly reduces reserves; Abate says the price of liquidity is rising, particularly for foreign banks active in Fed funds. Costs and benefits of abundant reserves: Abate argues that ample reserves can strengthen bank liquidity, but an oversupply may encourage banks to hold more reserves than needed and contribute to balance-sheet distortions. During QE, abundant deposits and securities holdings could leave banks more exposed to rate-sensitive funding outflows, as seen in March 2023. Stablecoins, Treasury bills, and global debt: Stablecoin issuers could become buyers of short-term Treasuries, but Abate views payment tokens as closer substitutes for currency than bank deposits, with potential demand from offshore users and remittances. Separately, he attributes widening swap spreads across several countries to a growing premium for government debt amid deteriorating fiscal outlooks.

Key Arguments: The Fed’s choice of benchmark matters not only for describing policy but also for how policy expectations transmit into deposit, mortgage, and longer-term borrowing rates. Fed funds has become a relatively inactive, segmented market under abundant reserves; an active repo-market measure could better indicate whether liquidity conditions remain within the Fed’s intended range. A large reserve supply can support bank safety, but excess reserves may encourage inefficient holdings and contribute to banking vulnerabilities when rate-sensitive deposits leave quickly. As QT continues and Treasury cash balances rise, reserves are increasingly bearing the impact of balance-sheet contraction, raising the marginal cost of liquidity. Stablecoins could increase demand for Treasury bills, but that outcome depends on adoption and on whether payment tokens substitute for cash, deposits, or other payment instruments. Widening swap spreads in multiple countries may reflect investors demanding greater compensation to hold expanding government debt, rather than a uniquely U.S. fiscal concern.

Data Points: Shift toward abundant-reserve framework: Beginning around 2008 - Abate describes the Fed’s transition away from the scarce-reserve operating framework. Fed funds spread between lenders and borrowers: About -7 basis points - Abate says the spread between the relevant Fed funds rate and IORB had been very stable for roughly four years under abundant reserves. Public communication of Fed target rate: 1994; target published in FOMC minutes in 1995 - Abate recalls changes in how the Fed communicated its target. Possible timeframe for changing the Fed’s target instrument: Not within the next two years - Abate expects discussion or action may be sooner than some anticipate, but not an implementation in the near term. Treasury cash-balance goal: Five to seven days of expected outflows - The Treasury’s target cash balance at the Fed drains reserves from the banking system. Average currency carried on-person: About $60 - Abate contrasts cash carried by individuals with the much larger amount of currency outstanding per capita. U.S. currency outstanding per capita: About $7,000 or more - The discussion uses this figure to illustrate that much U.S. currency is held rather than routinely carried or spent domestically. Share of U.S. currency estimated to be held offshore: Approximately five-eighths - Abate says estimates suggest a substantial share of U.S. currency is held outside the country.

Pivotal Quotes: "The reason you care about the plumbing is that the Fed uses it to communicate its policy intentions." — Joe Abate: He explains why the mechanics of short-term money markets matter beyond technical market details. "So reserves may be ample at the moment, but their price is going up because the amount of that ampleness is getting smaller and smaller." — Joe Abate: He summarizes how declining reserve levels can increase the cost of liquidity even before reserves are considered scarce. "I would argue that having plenty of reserves in the system increases the safety of banks." — Joe Abate: He presents the counterargument to focusing solely on balance-sheet efficiency and reserve reduction.

Implications: A move from Fed funds toward a repo benchmark could change how markets interpret policy and liquidity. Continued reserve runoff may raise funding costs and expose bank vulnerabilities, while stablecoin growth and expanding public debt could reshape demand for Treasury bills and government bonds.