FILE PHOTO: Federal Reserve Bank of Dallas President Lorie Logan attends an event with the Borderplex Alliance in El Paso, Texas, U.S., May 30 2024. REUTERS/Ann Saphir/File Photo

By Michael S. Derby

(Reuters) -Federal Reserve Bank of Dallas President Lorie Logan said on Thursday the time has come for the central bank to modernize how it manages money market conditions to achieve its monetary policy objectives.

To do this, Logan said the central bank’s long-standing practice of targeting the federal funds lending market to achieve a given level of short-term interest rates needs to shift. Instead, the Fed should manage liquidity to control the trading level of the tri-party general collateral rate, or TGCR, given the vibrancy of that market.

“The time has come for the [Federal Open Market Committee] to prepare to target a different short-term interest rate,” Logan said in the text of a speech prepared for delivery before an event at the Richmond Fed.

Logan cautioned that such a change is technical and aimed at making monetary policy implementation more effective. The Dallas Fed president managed the implementation of monetary policy at the New York Fed before she took the helm of the regional Fed bank.

The official said targeting the TGCR is the “best” option because that market is very active and “the Fed’s existing tools already provide effective control” of the rate. As for the status quo, “while targeting fed funds currently provides effective control of broader monetary conditions, the connections are fragile and could break suddenly. The FOMC should take that risk off the table,” Logan said.

The central banker’s call for reform of how the Fed manages its rate target comes as the central bank is about to face a challenging period of keeping its interest rate target in line. At the end of this month liquidity conditions are likely to temporarily tighten in such a way cash will flood into Fed liquidity facilities, which are in place to help keep money market rates in line with the levels set out by the FOMC.

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As it now stands, the Fed seeks to achieve its employment and inflation mandates by shifting the setting of the federal funds rate, which is now at between 4% and 4.25% after last week’s quarter percentage point rate cut. That rate is managed by two other rates, one that pays banks for reserves and another that pays money market funds for cash. These two rates bound the high and low ends of the fed funds range.

The challenge for the Fed is that the federal funds market, where banks lend and borrow reserves, has dried up in the wake of the central bank flooding markets with reserves as it navigated the financial crisis and the COVID-19 pandemic. The Fed currently aims to keep enough liquidity in the financial system to allow for firm control over its interest rate target.

Some have argued that the Fed’s administered rates that guide the funds rate should become the formal targets, but Logan pushed back on that, saying those two rates "will always be exactly what the Fed wants them to be.” Logan also said there are issues with the Fed trying to manage a rate based on a constellation of other money market rates.

Logan said targeting the TGCR would still allow for some movement in that rate and the central bank would not need to provide “pinpoint control to the basis point.”

“It would be perfectly fine, in my view, for TGCR to move up and down from day to day, much as it has for many years,” Logan said. “After all, the target range is 25 basis points wide,” she said, adding “a tolerance for modest volatility would allow us to maintain rate control with our current simple and efficient tools, without large, frequent or complex operations.”

Market participants were not surprised by Logan's interest in changing the central bank's rate control system.

Logan's plan "makes a lot of sense," said Jan Nevruzi, a strategist at TD Securities. But he added "repo has more inherent daily volatility" relative to the federal funds market, which could mean the central bank might have to close off its balance sheet contraction process sooner than currently expected.

The Fed has been drawing reserves out of the system since 2022 by allowing a set amount of Treasury and mortgage bonds to expire each month and not be replaced, taking its holdings from a peak of $9 trillion to the current $6.7 trillion mark. The Fed is expected to press forward into next year with this effort and could take a little more than $500 billion more off that tally.

But if liquidity draws short faster than expected--that's a real possibility in the view of many market participants--the so-called quantitative tightening process may end soon to allow the Fed to maintain firm interest rate control.

Logan said in her remarks that evolutions in money market conditions are likely to force a shift at some point, and it would be better to be ahead of the curve rather than forced into action. “If the target rate must change, the best time for a change would be when markets are functioning smoothly and market participants can have plenty of advance notice,” she said.

Lou Crandall, chief economist at Wrightson ICAP, a research firm, said Logan's case has "a lot of merit" and "the Fed needs a back-up plan in case the funds rate starts deviating more from the overall level of more relevant market rates like the TGCR."

(Reporting by Michael S. Derby; Editing by Anna Driver)