Should the Fed Target Libor?

Many thanks to Colin Barr, who saw my question about how we can bring down Libor and pointed me to a recent essay by Edwin Truman with a very specific proposal about doing just that. Truman takes the very direct approach:

The FOMC should temporarily shift its target from the overnight federal funds rate to the 3-month dollar LIBOR rate. If its notional target for the federal funds rate remains at 2.00 percent, the FOMC should target LIBOR at 2.09 percent. (A useful byproduct would be to loosen up the calibration of Federal Reserve policy from increments of 25 basis points.) If the FOMC were to reduce its notional federal funds target to 1.50 percent, the actual target of policy should be expressed as a 3-month LIBOR of 1.59 percent.

The desk of the Federal Reserve Bank of New York (FRBNY) would implement this policy by aggressively providing reserves to financial institutions using the full range of its expanded facilities to provide liquidity to the market, including traditional repurchase agreements (repo). It would continue to provide reserves until 3-month LIBOR reached the FOMC’s newly expressed target. The actual federal funds rate will decline toward zero.

Note that Truman isn’t trying to get the spread between Fed funds and three-month Libor down to 9bp — that would be unrealistic. Fed funds, he says, under this proposal, would essentially go to zero. And then the Fed would continue to pump liquidity into the system, until Libor eventually came down.

Truman notes that this is not quite as crazy as it might at first seem: in fact, the boring Swiss have been doing it for years.

The Swiss National Bank (SNB) expresses its policy as the midpoint of a target range for 3-month Swiss franc LIBOR and seeks to achieve that target primarily via interventions in the market for one-week Swiss franc repurchase agreements (repos). During the crisis period, the SNB has generally been able to achieve its LIBOR target, which since late September 2007 has been a mid-point of 2.75 percent within a range of 2.25 and 3.25 percent, even as the index for the overnight repo rate has dropped to 1.58 percent from about 2.25 percent a year ago.

The inflationary consequences of this approach might be quite profound — but on the other hand, the Fed is already pumping so much liquidity into the system that there might not be a huge difference, in terms of inflation, between what we’d get with Truman’s proposal and what we’re going to end up with anyway.

I was hoping that there might be some kind of artificial way of bringing down Libor — by instituting a Federal guarantee of short-term interbank loans, for instance. But failing that, the Truman’s brute-force approach does have its appeal.

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