(Reuters) -A Federal Reserve official's proposal to overhaul the central bank's interest rate target system is getting a warm reception but still faces long odds as the Fed's balance sheet wind-down nears conclusion and Fed leadership is due to change next year.

Dallas Fed President Lorie Logan, who previously ran the New York Fed's open market operations, last month proposed changing the interest rate targeted by the Fed from the federal funds rate, the focus of monetary policy for decades, to the tri-party general collateral rate, or TGCR. 

As the Fed has embraced large-scale asset purchases during and after the 2007-2009 financial crisis to help achieve its inflation and employment goals, activity in the once-vibrant fed funds market, where banks lend each other overnight reserves at rates near the target range set by the Fed, has largely dried up. Barclays, for instance, estimates volumes in the TGCR market total over $1 trillion per day versus just $100 billion per day in fed funds trading.

Against that backdrop, Logan sees TGCR - the rate for short-term loans collateralized by bonds - as a better barometer of the money market conditions that affect the broader economy and argues the Fed should manage it instead.

Targeting TGCR would leave in place the reverse repo and standing repo facilities the Fed uses to manage the fed funds rate. It would likely do the same for a TGCR target, though some reckon the SRF would need some modifications to make it more attractive in that event. 

Logan argued now is a good time to make the change. The Fed has been drawing liquidity from the system for three years as it reduces its balance sheet, and short-term borrowing rates could become more volatile as this process moves forward, she noted. In a speech this month, Fed Chair Jerome Powell said the end of quantitative tightening could arrive "in coming months," as he cited a rise in money-market rate volatility. 

"I think there are merits" to Logan's idea, and "the timing could be good" to make a change, said Ellen Meade, a former high-ranking Fed staffer now at Duke University.

William Dudley, former head of the New York Fed who also led monetary policy implementation work, said Logan's proposal is "a perfectly reasonable thing to do," while adding such a move would be technical and "not really a change in terms of how monetary policy is actually conducted."

HEADWINDS TO CHANGE

Logan is an influential voice on monetary policy implementation, but it's unclear how much traction her idea has.

Fed officials, for starters, have affirmed the primacy of the fed funds rate to influence the economy for some time, and they agree it moves consistently where they want it to be, despite the reduced liquidity. They also say that most short-term rates move in the same direction, which downplays the benefits of changing to TGCR as their main economic lever.

Moreover, Fed officials appear confident that their interest-rate-control toolkit is working well.

Powell, for one, appeared to favor the status quo in his remarks earlier this month, saying: "The bottom line is that our ample reserves regime has proven remarkably effective for implementing monetary policy and supporting economic and financial stability." 

Meanwhile, TGCR sees more volatility around events like tax dates and month- and quarter-ends than the fed funds rate does, which could make it harder to sift signal from noise.

"There would always be a risk that the Fed misidentifies higher repo rates as temporary moves, and these rates' trading at higher levels for prolonged periods could damage confidence in the Fed's ability to control the policy rate," Barclays said in a report that was otherwise supportive of the Fed changing its target. "Investors would likely be especially sensitive to this during any transition to a new benchmark."

That said, excessive volatility may also be coming to the fed funds market as the Fed presses forward with the  liquidity-draining balance sheet contraction, so a change may need to happen one way or another.

"The Fed has known for decades that a collapse of the fed funds market was a likely consequence of the giant balance sheet approach to monetary policy it is now using," said Bill Nelson, a former top-level Fed staffer who is now chief economist for the Bank Policy Institute lobbying group.

"The Fed clearly needs to do some robust contingency planning for the possibility of a transition to a new operating target," said Wrightson ICAP analysts in a recent note. That said, "we would be inclined to wait until the future landscape becomes clearer before making final decisions about the specifics."

If the Fed does start weighing the idea of a switch, it will likely be a slow process. The Fed first considered a move like this a decade ago when it was preparing to lift rates off the near-zero levels that prevailed after the financial crisis.

Another roadblock to a shift is likely tied to the succession process surrounding Powell, whose term as chair ends next May. Some Fed watchers say a decision around the rate target may be deferred until new leadership is in place, given that it ties into how the Fed manages its balance sheet.

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