Monetary Policy Implementation with Ample Reserves

Abstract

The Federal Reserve currently implements its interest rate policy under a framework known as the floor system. In order for the floor system to operate smoothly, there must be sufficient liquidity in the federal funds market. The ongoing goal of quantitative tightening (QT) is to reach the minimal level of market liquidity required to implement monetary policy efficiently and effectively, also known as an ample reserves regime. We briefly discuss changes in the monetary policy framework from the previous corridor system to today’s floor system as well as the circumstances that brought them about. Finally, this article complements the literature by proposing that liquidity changes in the composition of bank deposits since the COVID-19 pandemic, paired with modifications in savings account regulation, play an important role in increasing the demand for bank reserves, thus raising the threshold for what may be considered ample. A simple econometric analysis confirms our conjecture. Therefore, the composition of bank deposits should be considered when performing QT policy.

Introduction

In response to the Great Financial Crisis (GFC), the Federal Reserve used its balance sheet capacity to purchase government bonds and other longer-dated assets, a process known as quantitative easing (QE) that was meant to increase the money supply and revitalize the American economy. As a result of QE policy, the size of the Fed’s balance sheet has expanded in accordance with the increased amount of bank reserves supplied to the banking sector. The rise in reserves has changed the framework in which monetary policy—or, more specifically, interest rate policy—is implemented. The previous framework, known as the corridor system, relied on a limited amount of reserves to effectively operate and as such is no longer suitable for monetary policy given the new state of the Fed’s balance sheet. Consequently, the Fed has developed a new monetary policy framework, commonly referred to as the floor system, which relies on a new policy tool that involves paying interest on bank reserves. By paying this interest, the Fed can impose a rate floor on the federal funds market. In simple terms, interest rate policy is presently carried out through the determination of the interest rate on bank reserves (IORB).

For the floor system to continue to function smoothly and for the IORB rate to remain an effective policy tool, the Fed must maintain a sizable balance sheet. As such, the entire premise of the floor system relies on the reserve level being no less than that outlined by an ample reserves regime—a direct opposition to the corridor system. While there is no official definition of an ample reserves regime, ample reserves could be considered the minimal level of market liquidity required to implement monetary policy efficiently and effectively under this new system. Currently, however, the level of bank reserves on the market is considered abundant (i.e., higher than the minimum level). An ongoing goal of the Fed is to drain excess reserves such that the amount falls from “abundant” to “ample.” To do so, it uses a process known as quantitative tightening (QT). For QT policy to reach ample reserves, estimating the appropriate size of the Fed’s balance sheet is critical.

This article adds to the current literature by discussing an additional, so far overlooked, factor that may influence the level of reserves regarded as ample. This factor has arisen in the aftermath of the COVID-19 pandemic and suggests that the demand for bank reserves could deviate from its historical average. We argue that increased liquidity of private banks’ liabilities due to changes in both portfolio composition and savings account regulation, which state that banks must no longer impose a six-per-month limit on transactions, will increase reserve demand. In other words, holding more bank reserves would be advantageous for private depository institutions as reserves provide liquidity on the asset side of their balance sheet, offsetting the increased liquidity of their liability. A simple econometric analysis suggests that this factor could play an important role in pushing ample reserves to higher levels and thus should be considered when performing QT policy.