Should Fed abandon targeting fed funds rate and move instead to reverse repo rate?

An interesting paper by Joseph E. Gagnon of PIIE and Brian Sack of D. E. Shaw Group.

They say targeting Fed funds rate will be ineffective as an when Fed decides to exit from easy policy. A better tool would be reverse repo rate which will help Fed absorb liquidity:

The amount of assets held by the Federal Reserve has dramatically increased since 2009. It recently crossed $4 trillion and will likely peak at about $4.5 trillion. This increase is the result of the Fed’s large-scale asset purchase programs, which were intended to support economic growth. However, these purchases have created unprecedented amounts of liquidity in the financial system. Gagnon and Sack doubt that the Fed can smoothly conduct monetary policy along the lines of the previous operating framework in this environment of high liquidity.

Instead of reducing bank reserves to achieve a target level for the federal funds rate, they propose a new operating framework that would allow the Fed to maintain an elevated balance sheet along with abundant liquidity in the financial system. They argue that the Fed should set the rate at which it will offer overnight reverse repurchase agreements as its policy instrument, with the interest rate paid on bank reserves set at the same level. The federal funds rate would become just one of the various overnight interest rates determined by the market in the normal transmission of monetary policy.

So instead of focusing on the quantities focus on the price/interest rate. The reverse repo rate will set a floor below which no will park funds. As Fed increases the reverse repo rate this will increase the cost of these deposits at the Fed. And gradually, the banking reserves will be extinguished from the balance sheet gradually. 

So as RBI tries to become like Fed. Fed is trying to become like RBI. RBI did use both repo and reverse repo rates before it moved to just one policy rate Repo in 2010.

Most central banks have been under this position of deficit liquidity or balanced liquidity for much part of recent history. The idea was to just provide more and more liquidity.

How will they manage the surplus liquidity situation whenever they choose to exit? . Whether it happens via quantities or via interest rates will be interesting to see..


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