Interest rate targeting isn’t being advocated as an optimal intermediary target. Other regimes such as directly targeting NGDP or inflation through changes in the monetary base or other intermediate targets may be may be superior. This article seeks to share ideas to improve the effectiveness and equality of interest rate targeting.
The central bank (CB) could target a risk free interest rate of securities it issues directly instead of an interbank rate such as the federal funds rate indirectly through repurchase agreements (repo), reverse repurchase agreements and asset purchases and sales.
The CB may issue risk free securities similar in nature to treasuries of varying short term maturities and target the rate on these through affecting their supply and demand. This is more equitable and effective than targeting a repo rate such as is practiced in some countries. Repo lending under by the CB is inequitable because it is akin to a direct loan exclusively to banks at preferential rates when compared to the market rate. Reverse repo borrowing by the CB is also flawed because it is exclusively offered to banks and financial institutions and the central bank provides collateral to borrow or contract MB momentarily. CB borrowing is risk free so provision of collateral is unnecessary. The CB could issue securities that anyone can purchase in open auctions like is currently performed by US treasury direct system.
The fed could have a target size of securities of maybe 1% of GDP it maintains in order to sustain an interest rate targeting system. The interest rate could be targeted by expansion of MB through direct fed heli drops. An increase in the rate of MB expansion would decrease the short term interest rate and slowing the rate of MB increase would lift the interest rate. In exceptional circumstances the CB could contract the monetary base by increasing the supply of securities it issues while not growing the MB through heli drops. The CB could fine tune the interest rate by affecting the supply of securities it issues or purchases in the secondary market.