![]() ![]() One approach involved asking individual private banks what their minimum levels would be, then aggregating the answers.Īlternatively, the Fed could wait for market signals suggesting that the minimum level is close to being reached. In the prior normalization period - between 20 - the Fed faced similar challenges. How would the Fed know when the quantity of reserves has reached its minimum ample level? This question is not new. Doing this requires that the Fed provides a level of reserves that is ample but not too large: in short, a minimum level consistent with ample reserves. This added cost can push interbank rates below interest on reserves, as noted for example in the 2017 paper " Excess Reserves and Monetary Policy Implementation." To achieve good interest-rate control, the Fed needs to strike the right balance between possible balance sheet costs and any convenience yield on reserves remaining in the market. For this reason, when the Fed's balance sheet is very large and banks hold large quantities of reserves on their balance sheets, those holdings carry an additional and sometimes significant balance sheet cost. are heavily regulated and face significant capital requirements. There are several possible reasons to target a minimum, a critical one being improved interest rate control: Most banks active in the U.S. In its " Balance Sheet Normalization Principles and Plans," the Fed has also pledged that "the SOMA portfolio will hold no more securities than necessary for efficient and effective policy implementation." On the liability side of the Fed's balance sheet, this amounts to targeting a minimum level of ample level of reserves. Interest rate targeting is the approach the Fed uses to achieve its objectives of full employment and price stability, as mandated by Congress. Fluctuations in these rates impact different portions of the economy, from general asset markets to specific consumer credit such as car and credit card loans. As a result, when reserves are ample, the Fed is able to target and (tightly) control its desired level of short-term interest rates in the market by moving the interest paid on reserves (which can be precisely adjusted by fiat). ![]() This is important because policymakers decide the level of the interest on reserves, which is fixed at an administered rate. When this is the case, the interest rate in most interbank transactions will remain very close (and often equal) to the interest on reserves. In other words, banks should value the marginal unit of reserves for the interest on reserves that they earn, but not because that marginal unit facilitates the daily operations of the bank holding it in any meaningful way. "Ample" means that reserves are plentiful enough to not carry any significant convenience yield. The idea is for the Fed to maintain a balance sheet large enough to accommodate growth in currency in circulation plus an ample quantity of bank reserves. Ample ReservesĪmple reserves are a critical component in a floor system. 1 In this article, we provide an estimate of the level of reserves that the Fed might consider appropriate given those plans as well as an estimate of the date that such level might be reached, given current Fed-set parameters for the normalization process. With financial and economic conditions improving, the Fed started the process of balance sheet normalization in March 2022, whereby it intends to significantly reduce the amount of Treasuries and mortgage-backed securities (MBS) that it holds in its System Open Market Account (SOMA) portfolio.Īs this process continues, a critical question is: How much further can the balance sheet be reduced? In its Balance Sheet Normalization Principles and Plans, the Fed expressed its desire to have a balance sheet consistent with a "floor system" for monetary policy implementation. Reserves in the banking system increased to record highs, well beyond levels desired by the Fed in the long run. The Fed has stated that, in the longer run, it intends to provide the minimum level of reserves consistent with being considered abundant or "ample." From the beginning of the pandemic through the spring of 2022, the Fed's balance sheet increased significantly due to the Fed's efforts to aid market functioning and support the flow of credit to households and businesses. The size and composition of the Federal Reserve's balance sheet is a critical consideration in designing an effective approach to monetary policy implementation. ![]()
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