Maybe Destabilizing the Overnight Lending Market Would Be a Good Thing

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Stephen Williamson has a long post up today questioning the wisdom of having the Fed adopt NGDP targeting, someting that enjoyed a boomlet of blogosphere chatter a few months ago. Most of the post is above my pay grade, but something he said piqued my interest in a different subject. NGDP targeting, says Williamson, could produce instability in the overnight lending market:

I think there are benefits to financial market participants in having a predictable overnight interest rate, though I don’t think anyone has written down a rigorous rationale for that view. Who knows what would happen in overnight markets if the Fed attempted to peg the price of NGDP futures rather than the overnight fed funds rate? I don’t have any idea.

Tyler Cowen is more sanguine: “I believe overnight financial markets could adjust to a variety of reasonable regimes, and indeed the evidence across nations appears to confirm this.” But I have a different question: why should we care? The modern financial system is heavily reliant on overnight lending, and it’s the backbone of the shadow banking system. In 2008, the shadow banking system largely imploded, and a big part of the reason was its heavy reliance on ultra-short-term lending, which can be turned on and off almost instantly. When panic spread, the overnight spigot was turned off, and banks started to collapse. This was a major cause of the financial collapse and the resulting recession, and it’s the reason that the Basel III rules adopted a couple of years ago required banks to rely more on stable, long-term funding.

Nonetheless, the shadow banking system, and its overnight lending backbone, is still enormous. And although I suppose we’ve gone way too far down this path to turn back now, I have to wonder just what, on a systemic level, we gain from having our financial system so dependent on overnight lending? Even if the overnight market didn’t adjust well to NGDP targeting, and therefore shrunk, would that be an altogether bad thing?

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