Federal Reserve May Revamp Benchmark Rate Calculation

The Federal Reserve is considering changing the way it calculates its main policy interest rate by including a broader range of transactions, said Dennis Lockhart, president of the Atlanta Fed.

The federal funds rate, currently calculated on the basis of brokered trades of overnight loans of reserves between banks, would also include direct trades, Lockhart said in an interview with Bloomberg News. Adding eurodollar transactions is also a “possibility,” he said.

Broadening the number and variety of transactions used to calculate the federal funds rate would provide a more accurate picture of interbank lending activity. Data on direct transactions between banks in the federal funds market are not public, making it hard to estimate the effect of the revamped calculation. The Fed started collecting this data from 165 domestic banks and U.S. branches of foreign banks on April 1.

The volume of brokered trades in the federal funds market has declined since late 2008, when the central bank began flooding the banking system with cash through large-scale asset purchases in a bid to stimulate the economy. As a result, many banks hold reserves in excess of requirements, obviating their need to borrow in the market.

“People don’t borrow fed funds because they need overnight liquidity, which is fundamentally different than the way the market existed seven or eight years ago,” said Joseph Abate, a money-market strategist at Barclays Plc in New York.

“The market has kind of devolved into a way for banks to borrow liquidity and earn a spread.”

Home Loan

Brokered trading in the federal funds market now is comprised primarily of federal home-loan banks, which aren’t eligible to deposit excess funds at the Fed at 0.25 percent interest. Instead, the home-loan banks lend to foreign banks, which can then deposit the cash at the Fed.

At the Federal Open Market Committee’s June 17-18 meeting, “participants examined possibilities for changing the calculation of the effective federal funds rate in order to obtain a more robust measure of overnight bank funding rates,” according to minutes from the meeting released earlier this week.

The Financial Times earlier reported the potential changes.

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