ex-Fed officials@ (Adds context on Fed actions, quotes from investors)
NEW YORK, Sept 26 (Reuters) - Recent money market volatility shows the Federal Reserve needs to retool how it manages an essential part of the financial system to minimize disruptive market swings that pose risks to the economy, two former Fed officials said on Thursday.
"Volatility in this market threatens the functioning of markets more broadly and could ultimately hurt the economy," Brian Sack and Joseph Gagnon wrote in a blog published on Thursday. "A better approach is needed."
Sack previously ran the markets group for the New York Fed and is now director of global economics for the hedge fund D.E. Shaw. Gagnon, a former Fed official, is now a senior fellow at the Peterson Institute for International Economics.
They said they were not opposed to the Fed's "floor system," which it uses to set rates by paying interest on bank reserves. Still, they said the Fed should make changes to create a system that is more "resilient and effective."
Instead of prioritizing the federal funds rate, or what banks charge each other to borrow reserves overnight, when setting policy, they recommended that the central bank be explicit about its efforts to control the interest rate in the much larger repo market, which banks use to borrow from money market funds and other cash investors using securities as collateral.
They suggested that the Fed consider targeting the repo rate when setting policy instead of targeting the fed funds rate.
"The federal funds market is much smaller and less important than the repo market, so this directive is dangerously inadequate," they wrote.
Another step the Fed could take is to create a standing repo facility that banks could borrow from as needed, they said. Such a system could serve as a "guardrail" against "unexpected developments" that could push up money market rates, they wrote.
The authors also called on the Fed to hold more reserves overall. They stopped short of saying that current reserves are too low, instead arguing that it is smarter to hold more reserves overall because the level of reserves needed in the system are likely to change over time.
The New York Federal Reserve calmed the volatility in money markets last week by conducting a series of cash injections into overnight lending markets. The bank also said it would continue the repo operations until Oct. 10, ensuring that cash markets will be liquid through the end of the quarter.
On Monday, New York Federal Reserve President John Williams said Fed officials are monitoring markets and will "assess the implications for the appropriate level of reserves and time to resume organic growth of the Federal Reserves balance sheet."
Some investors say the temporary operations have been addressed the problem for now, but they want to know what the Fed will do to increase liquidity over the longer term.
"Were stepping into scarcity right now," said Shahid Ladha, head of strategy for G10 rates Americas at BNP Paribas. "They definitely need a more permanent liquidity injection."
Gagnon said in an interview that he does not view the money market volatility as a loud warning signal for the economy. But he said investors would like to see a system where the response from the Fed could be more predictable.
"We dont think were anywhere near some sort of crisis," he said. "I think the Fed is responding. Its just a question of why not make the Feds response more automatic." (Reporting by Jonnelle Marte and Richard LeongEditing by Jacqueline Wong and Cynthia Osterman)