During a press conference following last week’s meeting of the Federal Open Market Committee (FOMC), Federal Reserve Chair Jerome Powell pointed out that the Fed has made “consequential decisions” about its balance sheet in recent months, including to maintain its current framework for implementing monetary policy and to slow the pace at which it allows maturing securities to run off. A speech last month by New York Fed senior vice president Lorie Logan provides helpful context around questions about balance sheet normalization and how the Fed could implement monetary policy going forward in light of these decisions by the FOMC.
Since the financial crisis, the Fed has been using an implementation framework based on an ample supply of reserves in the banking system, with short-term interest rates controlled by administered rates such as those paid on bank reserves. Prior to the crisis, by contrast, the Fed implemented monetary policy in an environment of scarce reserves, and it exerted control over interest rates by influencing the supply of reserves in the banking system. (For more on how policy implementation differs between these frameworks, see this speech by Logan from May 2017.) In her recent remarks, Logan stressed that while the New York Fed’s Open Market Trading Desk now has a decade of experience operating in an ample-reserves regime, opportunities for learning are ongoing, especially when it comes to understanding banks’ demand for reserves.
So, what exactly is happening here?
“Whereas the size of the balance sheet and the level of reserves have, for many years, been driven by Federal Reserve asset policies, at some point they will be determined by the demand for Federal Reserve liabilities, taking into account both the banking system’s demand for reserves and volatility in non-reserve liabilities.”
In other words, the Fed greatly expanded its balance sheet in the years after the crisis through its purchases of Treasuries and agency mortgage-backed securities, which impacted the asset side of the balance sheet. However, the longer-run size of the balance sheet will be driven by demand for liabilities such as reserves, currency, and the Treasury General Account.
And, as Logan put it, “The factors determining that demand are complex and may change over time.”
Still, she noted that while reserves “will continue to be ample going forward, the level will be significantly lower than has prevailed in recent years.” At the same time, “there are new factors driving reserve demand, and that demand is, and will likely continue to be, much higher than it was before the crisis.”
What are the advantages of the ample-reserves regime?
For one, it has been “very effective at controlling short-term interest rates,” and that is expected to continue even if “unexpected situations arise in which large amounts of liquidity need to be added to relieve stress in the banking system. For another, “shocks to the supply of or demand for reserves can be absorbed without the need for sizable daily interventions by the central bank.”
Logan also addressed the fact that the effective federal funds rate has recently risen above the rate of interest on excess reserves (IOER) the Fed pays:
“As long as these rates remain relatively stable and at modest spreads above IOER, we don’t see this as indicating that reserves are not well supplied. Indeed, an examination of daily reserve levels of individual banks shows that currently most banks remain well above their reported [lowest comfortable level of reserves], suggesting that reserves remain ample.”
She concluded by highlighting the importance of flexibility and adaptation for the Fed:
“These are unprecedented times, so active learning and maintaining operational flexibility will continue to be core principles that guide the implementation of monetary policy.”
This article was originally published by the New York Fed on Medium.
The views expressed in this article are those of the contributing authors and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.
