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

Episode Summary

Executive Summary: This 'Odd Lots' episode explores the evolving mechanics of Federal Reserve interest rate targeting, featuring Joe Abate (ex-Barclays, now SMBC Nikko). The conversation explains the shift from a scarce-reserve regime to an abundant-reserve one post-2008, the resultant change in the Fed funds market (now a 'Roman lake' driven by arbitrage), and the implications of Dallas Fed's Lori Logan suggesting a move to target the tri-party repo rate instead of Fed funds. The episode also touches on declining reserve levels, rising liquidity costs, the impact of quantitative tightening and stablecoins, and global trends in fiscal prudence affecting swap spreads.

Main Topics: Evolution of Fed Interest Rate Targeting Mechanics (Priority: 5/5): Detailed exploration of the shift from a scarce-reserve regime to an abundant-reserve regime post-2008, and how the Fed funds market changed from a funding market to an arbitrage market (Roman lake). Potential Shift to Tri-Party Repo Rate as New Fed Target (Priority: 5/5): Lori Logan of the Dallas Fed proposed potentially moving away from targeting Fed funds to targeting the tri-party repo rate, discussed along with the technical and political challenges. Impact of Quantitative Tightening and Declining Reserves (Priority: 4/5): Reserves are still ample but declining; the end of RRP usage means further QT will drain reserves directly, raising the cost of liquidity and affecting market functioning. Stablecoins and Their Interaction with Money Markets (Priority: 3/5): The role of stablecoins as a payment mechanism (substitute for bank deposits and currency) and their potential to become large buyers of T-bills, with implications for Treasury issuance. Global Swap Spread Widening and Fiscal Prudence (Priority: 4/5): Discussion on why swap spreads are widening globally (U.S., Japan, Canada, Australia) due to rising government debt and fiscal sustainability concerns, pushing up term premia. Tri-Party Repo vs. SOFR as Policy Rate Indicator (Priority: 3/5): Explanation of the distinction between tri-party repo (pure financing) and SOFR (includes bilateral repo for specific securities), and why tri-party might be a better barometer for the Fed.

Key Arguments: The Fed funds market is no longer representative of genuine borrowing demand; it has become a narrow arbitrage market (Roman lake) because abundant reserves have eliminated the need for banks to borrow reserves. Lori Logan's suggestion to switch to targeting the tri-party repo rate instead of Fed funds would help the Fed better measure liquidity conditions and run a more efficient balance sheet. Stablecoins act as a substitute for physical currency (especially $100 bills) and could become a large buyer of Treasury bills, potentially allowing the Treasury to issue more short-term debt without increasing rates. Global swap spreads are widening due to a general trend of rising government debt and fiscal deterioration—not just in the U.S., but across developed economies. The run-down of the Fed's balance sheet via QT is now draining reserves (after the RRP facility dried up), and this is disproportionately affecting foreign banks, raising their cost of liquidity.

Data Points: Stable spread between Fed funds and IORB: Minus 7 basis points - Discussion of the Fed funds rate target vs. traded rates U.S. currency held offshore: 5/8 of total U.S. currency - U.S. currency held offshore as a share of total Per capita currency in U.S.: $7,000 (approx.) - U.S. currency per capita Average on-person currency: $60 - Average currency held on person in U.S. Targeted days of expected outflows: 5-7 days - Treasury's cash balance target Number of $100 bills in circulation: 19 billion - The number of $100 bills outstanding Potential new buyer for Treasury bills: Large buyer needed to absorb increased supply without pushing interest rates up - Effect of stablecoin demand on Treasury bills

Pivotal Quotes: "So the market kind of devolved into basically an interest rate arbitrage. ... It's become kind of a Roman lake, right? The provinces around the Mediterranean all spoke Latin." — Joe Abate: Joe Abate describing the transformation of the Fed funds market after the shift to abundant reserves. "Who cares? Who cares about the any of this? ... In the end, even if it's not targeting one or the other, the short-term interest rate is basically where the Fed wants it by any of these measures. So, literally, who cares about the plumbing?" — Tracy Alloway (implied from context): Host questioning why listeners should care about the technical differences between rates and the plumbing of the Fed. "The Fed uses it to communicate its policy intentions. So it needs some sort of barometer, some sort of measure for the market to be able to interpret what the Fed's intentions are." — Joe Abate: Joe Abate explaining the Fed's need for a robust communication device from an active market to manage balance sheet efficiency.

Implications: Listeners should anticipate potential shifts in how the Fed communicates and implements policy, possibly targeting the tri-party repo rate, which could impact money market mechanics, liquidity management, and the transmission of monetary policy. The decline in reserves, combined with QT and Treasury cash management, may lead to higher short-term funding costs. Additionally, the rise of stablecoins could reshape demand for short-duration assets, potentially easing Treasury issuance pressures, while the growing fiscal debt globally is increasing term premia and swap spreads, signaling higher interest rate volatility.