**MNI ANALYSIS:Funding Pressure Could Spur Fed Operation Shift

--Effective FFR Just 5bp Shy of Upper Bound of FOMC's Target Range

--Declining Excess Reserves Amid Balance Sheet Roll-Off Helps Drive EFFR Higher

--Fed Paper Suggests EFFR Breaches Upper Range When Reserves Fall to $500B-$1.1T

By Jean Yung

     WASHINGTON (MNI) - Incoming Federal Reserve Bank of New York President John

Williams made his name as a distinguished economist, but his first big challenge

in the Second District may be a market dilemma: how to adapt the Fed's

operational framework for implementing monetary policy to fit a changing market

landscape.

     At issue is the workability of the so-called "floor" system in an era of

rising funding pressures, which have narrowed the gap between the effective fed

funds rate and the upper bound of Fed's target range from 9 basis points last

year to just 5 this week. Ongoing balance sheet reduction will likely drive the

supply of bank reserves lower still, potentially pushing the funds rate outside

the 25-basis-point range.

     In a floor system, reserves are abundant and the interest rate the Fed pays

on excess reserves, or IOER, is the primary tool used to guide the federal funds

rate. Prior to the financial crisis, the Fed utilized a "corridor" system in

which reserves were scarce, and it performed daily open market operations to

balance supply and demand at the FOMC's target rate.

     When the Federal Open Market Committee reconsidered the operating framework

in late 2016 as they prepared to begin shedding assets, officials emphasized the

efficiency and flexibility of the floor system. Outgoing New York Fed chief Bill

Dudley said last month that the case for retaining the floor system is "very

compelling." 

     But as the effective fed funds rate has steadily marched higher and hit

1.70% this week, new attention has focused on the market for interbank loans

with potentially far-reaching consequences for how the Fed implements monetary

policy. 

     --SHRINKING RESERVES

     Since the beginning of April, the spread between IOER and the effective fed

funds rate has averaged 6 basis points with analysts speculating it could

compress further. 

     Declining excess reserves spurred by the Fed's balance sheet unwind as well

as a surge in Treasury bill issuance have driven the spread narrowing. The

elimination of the FDIC's deposit insurance surcharge later this year may also

exacerbate the trend. 

     Reserve balances were near zero in early 2008 and rose rapidly to nearly

$2.75 trillion in 2015 as the Fed embarked on large-scale asset purchases. The

contraction in reserves since the start of 2018 has been modest -- they

currently stand at around $2.0 trillion -- but the effective fed funds rate

climbed 3 or 4 basis points during this time. 

     Research by New York and Philadelphia Fed economists published in February

suggests that the effective fed funds rate will rise above the upper bound of

the target range when excess reserves enter the vicinity of $500 billion to $1.1

trillion. Given the current pace of passive roll-offs of Fed assets, that could

take about two years time. 

     --POSSIBLE REFORMS

     Yet the gap between the effective funds rate and the upper bound of the

target range has compressed more rapidly than the Fed authors anticipated,

adding a sense of urgency to the discussion.

     If the Fed sticks with a floor system, it could consider de-linking IOER

from the upper bound of the target range and instead set it at a rate that will

ensure the effective fed funds rate falls within its target range. 

     The FOMC could also switch to a simple point target for the fed funds rate,

with the understanding that the effective rate might miss the target some of the

time. 

     Any reforms will likely come before the Fed determines the ultimate resting

level of the balance sheet, a process that could take years. If it chooses to

return to the pre-crisis corridor system, it would likely need to shrink the

balance sheet more than in a floor system to ensure sufficient scarcity of

reserves. 

     Changes to the Fed's operating framework could also be coupled with other

potential reforms, including the choice of its key policy interest rate. While

the Fed has long benchmarked monetary policy against the fed funds effective

rate, in recent years the New York Fed has begun publishing alternative rates,

including the Overnight Bank Funding Rate, which includes an expanded basket of

unsecured lending transactions, and the Secured Overnight Funding Rate, which

covers a large universe of repo-based transactions.

     Last summer, Fed Chair Jay Powell, speaking at the time as a Fed governor,

stress that the choice of operating framework is not "a decision we're making

today, or in the very near future. ... In the longer run, my own view would be

that maybe the floor system is more robust." 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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