Should the FOMC End Fed Funds Targeting? Issue CMOs?

November 5, 2025 | Should the Federal Open Market Committee stop targeting the short-term funds market as a policy tool? The Federal Reserve began setting explicit targets for the federal funds rate in the 1970s. Before this, the Fed monitored the rate going back to the 1960s and used open-market operations to influence the supply of reserves to keep the rate in a desired range, but the 1970s marked the beginning of explicit targets. 

In effect the Fed nationalized the short-term funds market fifty years ago, in part because changing the targets was simple from a policy perspective and easy for the inane political class in Washington to understand. After 2008 when short-term interest rates reached zero, however, the FOMC under Chairman Ben Bernanke initiated “quantitative easing," Orwellian newspeak for massive purchases of securities and thereby embraced a policy of providing excessive reserves to the short-term markets. Bernanke’s policy shift was essential, but like most central bankers, he did too much (See: “Should the Federal Reserve Pay Interest on Bank Reserves?”). 

Bill Nelson at Bank Policy Institute described the history in an October 8, 2025 missive:

“Prior to 2008, reserve balances (deposits of banks at Federal Reserve Banks) did not earn interest, so banks sought to minimize their balances, maintaining just the amount needed for clearing needs and to satisfy reserve requirements.  By adjusting its balance sheet, the Fed provided the banking system the amount of reserves balances banks demanded in aggregate, although each bank ended up at the end of the day with a bit more or less than it wanted. Most activity in the fed funds market consisted of banks with extra reserve balances at the end of the day lending to those that were short of reserves. Now, banks earn interest on reserve balances they keep at the Fed, and the Fed’s massive balance sheet has flooded reserves far beyond what banks need, pushing the fed funds rate below the amount banks earn on reserves. Banks now have no incentive to lend extra reserves into the fed funds market, so these end-of-day transactions have nearly ceased.”

Nelson notes that some FOMC participants recommended that the Fed address the potential imminent demise of the fed funds market by switching to targeting the rate for forward Treasury and MBS repurchase agreements (see Logan and Schulhofer-Wohl).  “Doing so would make it even more difficult for the Fed to return to its pre-GFC light market footprint,” he notes.

FRB Dallas President Lori Logan is not an advocate for a large Federal Reserve balance sheet; instead, she supports shrinking it gradually, but targeting the vast, $5 trillion plus market for repurchase agreements seems inconsistent with that position. The context behind the discussion of targeting the dying fed funds market is the massive federal budget deficit. The size of the Treasury General Account (TGA) is such that the flows of cash now dominate the money markets.

Wolf Street has been documenting the dysfunction in the Fed-dominated money markets with several excellent posts last week:

“[Overnight Reverse Repurchase  Agreements] spiked to $52 billion today. A week ago, it was essentially zero. Spiking ON RRP balances at the end of the month and at the end of the quarter have been normal, and this spike was rather small, compared to the prior spikes. This $52 billion of ON RRPs counterbalanced the $50 billion drawn on the SRF facility today, and the net liquidity added by the Fed – so SRF balance minus ON RRP balance – was less than zero. In other words, the ON RRP facility effectively withdrew $52 billion in liquidity from the repo market, while banks borrowed $50 billion from the Fed via the SRF to supply liquidity to the market.” 

Nelson notes that some FOMC participants have recommended that the Fed address the potential imminent demise of the fed funds market by switching to targeting the repo rate (see Logan and Schulhofer-Wohl). “Staff in 2018 did not think it was feasible to target the repo rate unless the Fed were operating a massive-reserves regime. Thus, a decision to switch to a repo target would be yet another instance where the Fed addressed a problem of its own making by concluding that the best solution is even more Fed.”

"The repo rate is a bit abstract but it is a better mechanical target for the policy rate," notes former FRBNY economist Robert Brusca, who we interviewed last June ("Interview: Robert Brusca on the Federal Open Market Committee"). "As for targeting GDP?? What does it matter what they target if they do not hit it and are not committed to hitting it? The Fed cannot switch targets until it can hit this one, at least without massively losing credibility. A Cleveland Fed survey already has the business community thinking that the REAL target for inflation is 2.5%"

Brusca penned a comment on Substack, "Has the Fed Abused Its Independence," which looks at many of these issues and the history of the Fed's dismal track record of federal funds targeting. Our view is that private financial markets do not need more of the Fed’s heavy hand, but the size of the federal debt and the TGA deposited at the Fed means that the Fed’s balance sheet must grow in proportion to the debt.

The growing federal debt is inflationary by definition. Fed officials don’t discuss an explicit link between the balance sheet and the size of the public debt, but we wonder if there is an "assumed" implicit ratio between the size of the central bank’s balance sheet and the TGA. Fed Vice Chairman Michelle Bowman observed in a September 2025 speech that “[it] is not the Fed’s role to replace or arbitrage private-market activities.”  She continued:

“Over the longer run, my preference is to maintain the smallest balance sheet possible with reserve balances at a level closer to scarce than ample. First, a smaller balance sheet would minimize the Fed's footprint in money markets and in Treasury markets. Of course, in order to efficiently implement monetary policy, it is necessary to have some footprint in these markets. Second, holding less-than-ample reserves would return us to a place where we are actively managing our balance sheet, identifying instead of masking signals of market stress. In my view, actively managing our balance sheet would give a more timely indication of stress and market functioning issues, as allowing a modest amount of volatility in money markets can enhance our understanding of market clearing points.”

So if targeting the repo market is a bad idea, what is the alternative? David Beckworth at the Mercatus Center at George Mason University has long argued that the FOMC needs to move from targeting fed funds to using nominal gross domestic product (GDP) as a policy target. In 2019 he published “Facts, Fears, and Functionality of NGDP Level Targeting.” More recently, David published a policy brief on NGDP Targeting is for the Fed’s framework review.

During the most recent FOMC press conference, Fed Chairman Jerome Powell lamented the conflicts and contradictions in the Fed’s current mandate: "I would say, again, we have a situation where the risks are to the upside for inflation, and to the downside for employment. We have one tool. We can't do both of those -- address both of those at once."

Beckworth writes:

“During the previous framework review in 2019–20, the Fed’s main monetary policy body—the FOMC—adopted the flexible average inflation targeting (FAIT) framework. FAIT aimed to address zero lower bound (ZLB) challenges by creating an asymmetric approach to the dual mandate: It would implement makeup policy on misses below the inflation target, and it would respond to shortfalls from maximum employment. These asymmetries, while well- intended, created an inflationary bias that caused FAIT to fail the “stress test” of the 2021–22 inflation surge. This failure caused the Fed to effectively abandon FAIT in early 2022 and become a single-mandate central bank focused on price stability. These developments indicate that the FAIT approach to the dual mandate is too narrowly focused and stands in need of an upgrade during the current framework review.”

Given the size of the federal deficit and the massive amounts of cash that the Fed maintains for the Treasury in the TGA, does the FOMC have any choice but to move away from targeting fed funds? Chairman Powell recently announced that the Fed will stop shrinking the system open market account (SOMA) in December (a/ka/a “QT,” but continued to allow MBS to run off, essentially “operation twist” in reverse (h/t Wolf). 

The Fed’s decision to end QT seems all according to plan, several observers told The IRA. The Fed pursued QT until markets showed signs of tightness. Now follows a period where currency growth shrinks reserves slowly until they are as low as they can achieve while still operating a floor system for interest rates with a buffer. 

Should the Fed Issue Collateralized Mortgage Obligations?

As Chairman Powell said in the latest FOMC presser, the SOMA reinvestment plan is intended to get their duration down to that of the Treasury debt outstanding by allowing long duration MBS to be replaced by short-duration T-bills. Could the Fed have continued to shrink the SOMA further as Bowman and others have urged? 

Some observers say that temporary open market operations would allow the Fed to go further with QT, but money market volatility last week suggests that the limit has been reached. As we’ve noted previously in The IRA, the Fed could and should sell the remaining $2 trillion in MBS into CMOs and move the badly needed duration back into the private markets. (See: "QT & Powell's Liquidity Trap").

CMOs allow issuers to transform long duration securities into tranches with short, medium and longer durations. The duration of the Fed's agency MBS portfolio is approximately 7.22 years, based on a 2024 analysis of its largest 30-year holdings. This figure represents the weighted average time until the portfolio's cash flows are paid out, and it is sensitive to changes in interest rates. For comparison, the average maturity of its entire balance sheet is around 107 months (or 8.9 years).

The Fed could sell "AAA" CMO short tranches to insurers and banks, and the longer "AA" tranches to other investors. The SOMA would retain the long-duration tails and sell them to life insurers when rates bottom. The massive leverage in the CMO tails could offset much of the losses to the Fed incurred to date. After all, this is what banks and other large mortgage investors do.  As we wrote in 2023 regarding the massive mark-to-market losses inside US banks and the SOMA:

"Federal Reserve Board Chairman Jerome Powell needs to lead a process to help banks and the GSEs extend maturities and timelines for loss realization. We need to do this before banks are forced to explain to investors later this year why they are reporting gigantic losses on assets they once intended to hold to maturity. And after we get the process started, the Fed itself should engage the GSEs to help slowly sell the SOMA MBS and return this duration to private hands. The GSEs need the business. Once the Fed sells its MBS portfolio, it will once again have control over the size of its balance sheet."

We noted in our column in National Mortgage News ("Reviving GSE MBS purchases would repeat the Fed's mistake") that a coalition of real estate and banking groups, including the Community Home Lenders of America and the Independent Community Bankers of America, wants Fannie Mae and Freddie Mac to buy conventional mortgage-backed securities to help the mortgage market. The GSEs would need to buy a lot of MBS to impact mortgage rates and, unlike the Fed, Fannie Mae and Freddie Mac must hedge their portfolios, muting any real impact of such purchases.

Thirty-Year FRM Minus 10-Year Treasury Yield

But restructuring the Fed's massive portfolio into CMOs would allow the central bank to exit its disastrous speculation in mortgage securities with minimal impact on the mortgage markets. The Street is starving for quality duration at the present time. If the central bank could somehow stop thinking that it controls the fixed income market and perhaps begin to use the market to help achieve policy goals, the FOMC could recover some credibility.

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