An important part of the Fed’s normalization policy is to reduce its holdings of securities and thereby reserve balances—deposits of banks at the Fed—used to finance these holdings. As I argued when quantitative easing began in 2009, this reduction should be predictable and strategic. That view was given some empirical support by the “taper tantrum” in 2013, when Ben Bernanke abruptly said in a congressional hearing that the Fed’s purchases of securities would taper in “the next few meetings.” In contrast, when the tapering later became more predictable, markets digested it easily.
The Addendum to the Policy Normalization Principles and Plans recently issued by the Fed conforms to this gradual and predictable approach. The Fed said it intends to reduce its holdings of Treasury and mortgage-backed securities by decreasing reinvestment of principal payments to the extent that they exceed gradually phased-in caps. As stated in the Addendum, the Fed “anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively. Gradually reducing the Federal Reserve’s securities holdings will result in a declining supply of reserve balances.”
The statement that the supply of reserve balances will decline in a gradual and predicable manner is welcome. But there is still the important question about what the Fed is aiming for. As explained in the Addendum, the “Committee currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.”
It is important that the Fed refers to reserve balances so much in this statement. There are two basic approaches to the question of what the Fed should aim for, and the level of reserve balances in the balance sheet is the key difference between them. One approach is for the Fed to aim at an eventual balance sheet and a corresponding level of reserve balances in which the interest rate is determined by the demand and supply of reserves—in other words, by market forces—rather than by an administered rate under interest on excess reserves. (To be sure, during the normalization or transition period with inherited high reserve balances, there is no choice but to use interest on excess reserves). Conceptually this means the Fed would eventually operate under a framework as it did in the two decades before crisis. Most likely the level of reserve balances will be greater than the levels of 2007, but that will depend on liquidity regulations. The defining concept of this approach is a market determined interest rate.
I think the case can be made for such a framework. The assessment of Peter Fisher, who ran the trading desk at the New York Fed for many years, is that such a framework would work. At the recent monetary policy conference at the Hoover Institution, he said “we could get back and manage it with quantities; it’s not impossible. We could just re-engineer the system and go back to the way we were.” I agree based on the time I spent in the markets for federal funds in those days watching how they operated and writing up an institutional description and model of how people traded in those markets. If we went back to that framework, there would not be any need for interest on excess reserves. If the Fed wanted to change the short term interest rate, it would just adjust the supply of reserves. The amount of reserves would be set so that the supply and demand for reserves determine the interest rate.
The Fed could also provide liquidity support if it needed to do so in this framework. Recall the events of 9/11 when the devastating physical damage led the Fed to provide effective lender of last resort loans. So you can have that kind of liquidity support in such a regime.
If it wanted to, the Fed could operate with corridor system in this framework. There would be a lower-interest rate on deposits at the floor of the corridor, a higher-interest rate on borrowing at the ceiling of the corridor, and, most important, a market-determined interest rate above the floor and below the ceiling.
This approach creates an important connection between the Fed’s policy interest rate and the amount of reserves or money in the system. The Fed is responsible for reserves and money, and that connection is important to maintain. Without that connection, you raise the chances of the Fed being a multipurpose institution, which leads people to raise questions about its independence. The Fed has already been involved in credit allocation with mortgage-backed securities purchases, and Charles Plosser argues it might do much more.
The second approach is a system where the quantity supplied of reserves remains well above the demand, and the interest rate is administered through interest on excess reserves as recently discussed along with other normalization issues by Fed Governor Powell. The method is sometimes called a “floor” system, but the federal funds rate moves a bit below the floor, so it is not really a floor. In any case, the interest rate is not market determined.
Those who support the second approach argue that more reserves than the amount needed to determine the interest rate are needed for liquidity purposes. Some (see Todd Keister) argue that the payment system doesn’t function well with a smaller amount of reserves. In the past there were large daylight overdrafts. However, one could limit the size of the overdrafts, perhaps as a percentage of collateral. There also may be some regulatory changes that would reduce the demand for liquidity.
Some argue that with a large balance sheet the Fed could provide depository services to regular people, just like it provides depository services to banks, with advantages described by John Cochrane here in an earlier conference volume. The Treasury could provide that service without interfering with the Fed’s operations, however, or there may be other ways to provide the service without creating a disconnect between the interest rate and reserves.
Others argue that a permanently large balance sheet with large reserve balances would allow quantitative easing to be used regularly. I don’t think quantitative easing has been that effective, and because there is uncertainty about its impact, it is hard to conduct a rules-based monetary policy with such interventions. Moreover, the spreading of quantitative easing across the international monetary system adds turbulence to exchange rates and capital flows.
In sum, we should not only be thinking about how to reduce the size of the balance sheet in a predictable, strategic way. We should also be thinking about where reserve balances are going. I think the first proposal described here makes sense. After the normalization, after the transition is finished, interest rates would again be determined by market forces.
