policy implementation with a large central bank balance sheet · policy implementation with a large...

The views expressed herein are my own and may not reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System

Policy Implementation with a Large Central Bank Balance Sheet

Antoine Martin

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Monetary policy implementation before 2008 Monetary policy implementation since 2008 The leaky floor Why are banks holding so many excess reserves?

Monetary policy normalization Framework Tools

Some implications for the long-term framework Is it costly to have a large balance sheet?

Outline

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Monetary policy implementation before 2008

Reserve balance

Interest rate

Target rate

Demand for reserves

Required reserves

DW rate

Target supply

0

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The level of reserve balances was quite low Averaged around $10 billion in 2006

Desk and Board staff forecast factors driving supply of and demand for reserves

Almost every day, conduct a repo operation to add enough reserves to hit the fed funds target rate Averaged about $5-10 billion per operation

As demand for currency grew, banks’ reserves would decrease, and the Desk would add reserves through purchases of Treasuries (long-run) and repos (short-run)

Pre-Crisis Operational Framework

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Framework was similar to a “corridor” system

Interest rate

Target rate

DW rate

Target supply

IOER

0

Required reserves

Demand for reserves

Reserve balances

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Outline

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The crisis lead to a huge increase in reserves

0

500

1000

1500

2000

2500

3000

(Billi

ons

of D

ollar

s)

2007 2008 2008 2009 2011 2012 2012 2013 2015

Reserve Balances with Federal Reserve Banks

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Monetary policy implementation since 2008

Interest rate

IOER

DW rate

Supply

Supply of reserves is not linked to target rate

0 Reserve balance

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Relatively recent authority granted to the Fed in 2008 Allows the Fed to pay interest to banks on the balances

that they leave in their account with the Fed How does it work? If banks can earn, say, 0.25% leaving money in their Fed

account, they won’t have an incentive to lend it out below that rate

Should provide a floor on interbank rates

Interest on excess reserves (IOER)

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The level of reserve balances is much higher Around $2.7 trillion; a 27,000% increase!

Little need to forecast factors driving supply of and demand for reserves each day But market interest rates, including the fed funds rate, have

been below IOER No need to conduct a repo operation to set the supply of

reserves to the desired level Relatively small-scale adjustments to the supply of reserves

might do little to move the fed funds rate Large-scale asset purchase programs have meant that

currency is no longer our largest single liability

Current Framework

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Reserves and Money Market Rates

-300

0-25

00-2

000-

1500

-100

0R

eser

ve B

alan

ces

(Bill

ions

)

0.1

.2.3

Rat

e (P

erce

nt)

Jan 10 Oct 10 Aug 11 Jun 12 Apr 13 Jan 14 Nov 14 Sep 15Date

GC Treasury Overnight Eurodollar (ED)

Fed Funds (FF) IOER

- (Total Reserves)

Sources: FRED, Federal Reserve Economic Data, from the Federal Reserve Bank of St. Louis,Bloomberg, and Federal Reserve Data Releases, H15

01 Jan 2010 - 30 Aug 2015

GC Treasury Overnight, Effective Fed Funds, IOER,Eurodollar, and Total Reserves

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The “leaky floor”

Interest rate

IOER

DW rate

Supply

Supply of reserves is not linked to target rate

0 Reserve balance

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Why is the federal funds (FF) rate below IOER? GSEs and FHLBs have Fed accounts but cannot earn

interest on reserves Why are other market rates below IOER? Most cash lenders in U.S. money markets are non-banks,

including MMFs, and do not have a Fed account

Why are market rates below the IOER?

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Absent frictions, we would expect competition to pull market interest rates close to IOER

Two frictions appear to limit the pull of IOER: Banks face balance sheet costs, related to new Basel III

regulation U.S. money market appear to be imperfectly competitive

Why doesn’t competition lift market rates

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Short answer: Because they have no choice Reserves are injected in the system when the Federal

Reserve purchases assets Reserves must be held by institutions that have a Fed

account Banks can redistribute the reserves among themselves

but cannot change the aggregate amount Except for turning reserves into currency

The analysis that follows is based on Keister and

McAndrews (2009)

Why are banks holding excess reserves?

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Before 2008: Low amount of reserves

Suppose there are two banks, A and B Balance sheets in normal times:

Reserves 10 Deposits 100 Reserves 10 Deposits 100Loans 50 Loans 130 Due toDue from Bank A 40 Bank B 40Securities 10 Capital 10 Securities 10 Capital 10

Bank A Bank B

Note: Interbank lending promotes the efficient allocation of resources

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The “crisis”

Suppose Bank A is no longer willing to lend to Bank B May have concerns about credit risk or about its own funding

needs If Bank B cannot replace this funding, it must reduce lending

Reserves 50 Deposits 100 Reserves 10 Deposits 100Loans 50 Loans 90 Due toDue from Bank A 0 Bank B 0Securities 10 Capital 10 Securities 10 Capital 10

Bank A Bank B

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Central bank response to the crisis

Suppose the central bank lends to Bank B The decrease in lending can be avoided This is the “lender of last resort” function of the central bank

Reserves 50 Deposits 100 Reserves 10 Deposits 100Loans 50 Loans 130 Due to

CB 40

Securities 10 Capital 10 Securities 10 Capital 10

Bank A Bank B

Note: total reserves are now $60, $40 of which are excess

The Central Bank’s policy is highly effective, even though it generates a large amount of excess reserves

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Bank lending and reserves

But … isn’t there a sense in which the $50 of reserves in Bank A’s account are idle? Don’t excess reserves represent “unused capacity” in the

banking system? Suppose Bank A lends $20 to Firm X, which is a customer

Reserves 50 Deposits 120 Reserves 10 Deposits 100Loans 70 Loans 130 Due to CB 40


Bank A Bank B

No change in reserve positions!

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Now suppose Firm X buys $20 in equipment from Firm Y Firm Y holds its account at Bank B

Reserves 30 Deposits 100 Reserves 30 Deposits 120Loans 70 Loans 130 Due to CB 40


Bank A Bank B

Reserves (and deposits) are transferred to Bank B

Again, no change in total reserves

The total level of reserves is determined entirely by the actions of the central bank (almost)

reveal nothing about the lending behavior of banks

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Outline

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Questions: Why are money market rates below IOER? Do we have the tools to raise market rates? If so, what is the most effective way to use our tools?

Monetary policy normalization

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Last September the FOMC published its Policy Normalization Principles and Plans. Fed intends to Keep a target range for the FF rate Move the FF rate primarily by adjusting IOER Use overnight reverse repos and other tools as needed Reduce securities primarily by ceasing reinvestments

3 tools have been discussed recently: IOER, overnight

RRP, and TDF What are they?

Exit and Patching the Leaks

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We build a simple model with households, firms, banks, and nonbanks

In our model: Households use the financial system to save for

consumption at a later date Firms produce consumption goods Banks lend to firm, offer deposits, and have access to IOER Nonbanks hold government debt on behalf of households

and cannot earn IOER

A framework

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Absent frictions, all money market rates would be equal to the IOER

There are three main frictions: Banks face convex balance sheet costs: Explains why

money market rates are below IOER Market for reserves may not be perfectly competitive Banks face convex interbank monitoring costs (reserve

scarcity): Explains why interbank rates are above IOER

Nonbanks do not face balance sheet costs because they are more transparent

Key Frictions

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Households Sell endowment to firm Save through banks and non-banks Buy goods for consumption later

Banks may experience a liquidity shock They may use reserves to absorb the shock or borrow in the

interbank market Firms Buy household endowment and use it as input for

production Sell goods to the households when they want to consume

A Simple Economy

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When the supply of reserves is small Interbank market is active Interbank market frictions are high Balance sheet costs are low Because of scarcity, banks compete for reserves

When the supply of reserves is high Interbank market is inactive Interbank market frictions are low Balance sheet costs are high Banks don’t need to compete for reserves

Two polar cases

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We study two tools (tested recently) Reverse Repurchase agreements (RRPs)

Banks and non-banks, such as MMFs, can lend to the Fed (against collateral)

We focus on fixed-rate overnight RRPs Term Deposit Facility (TDF)

Banks can deposit reserves with the Fed for a term maturity

We study other tools in the paper and could adapt the framework to study additional tools

New Federal Reserve Tools

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A tool we have used for decades New wrinkle: instead of operating in fixed size, operate at

a fixed rate with a broader set of firms How does it work? In tri-party repo system, investors give the Fed cash

overnight and we give them Treasury securities as collateral (essentially, a collateralized loan to the Fed)

Used to support a floor under rates Similar to IOER, if an investor can earn, say, 0.05%

investing at the Fed, why invest with a private counterparty below that level?

Overnight RRP

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A relatively new tool Similar to IOER in many ways, but instead of overnight,

deposit is for a specified term How does it work? Banks can choose to place a fixed amount of their reserves

in the TDF Used to support a floor under rates--why lend below TDF

rates?--and to drain reserves--transforms one type of liability (reserves) into another (TDF)

Typically needs to be offered above IOER; otherwise, why lock up your money for longer than you need to?

TDF

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The tools work by affecting the two frictions that determine interest rates: Balance sheet costs: Reducing balance sheet size raises

market rates by decreasing the spread to IOER Competition: Scarcity makes banks compete for reserves Interbank market frictions: Increasing the interbank market

activity raises interbank market rates Assessment: TDF: Creates reserve scarcity but does not affect balance

sheet size RRPs: Create reserves scarcity and reduce balance sheet

size (if RRP rate < IOER)

How do the tools affect the frictions?

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Yes, TDF and RRPs will help raise rates

Large reserves RRPs are more effective RRPs (but not TDF) reduce balance sheet size Creating scarcity through TDF only would require massive

drain of reserves

Do we have the tools to raise rates?

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Welfare in our economy can be measured as the (negative of the) sum of the three frictions

TDF: Increases rates in part by increasing interbank market costs Lower welfare

RRPs: Increase rates by lowering balance sheet costs and increasing interbank costs Trade-off: Effect on welfare can be ambiguous but likely

positive when reserves are large ON RRPs also stabilize rate by absorbing liquidly shocks

How should we use our tools?

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Outline

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What is the optimal supply of reserves? Trade-off: Reserves alleviate interbank market cost but

increase bank balance sheet costs Optimal amount is likely larger than pre-crisis supply Additional potential benefits: Improves timing of payments Increases public supply of safe assets

Implications for long-term framework

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One option: A “floor” system

Interest rate

IOER

DW rate

Supply

Supply of reserves is still not linked to target rate

0 reserve balance

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Consider a three period example The central bank that holds 2 period assets and 1 period

liabilities Assets bought at t pay 𝑅𝑡 Bank pays 𝑖𝑡 on reserves

Upward sloping yield curve 𝑅𝑡 = 𝑖𝑡 + 1

Central Bank Profits: 𝜋𝑡 = 100(𝑅𝑡 + 𝑅𝑡−1 − 2𝑖𝑡)

Is it costly to have a large supply of reserves?

New Assets 100 Reserves 200Old Assets 100

Central Bank

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Interest on reserves is Low 𝑖0 = 𝑖1 = 0.25%

Assets pay according to yield curve 𝑅0 = 𝑅1 = 1.25%

CB profits are positive 𝜋1 = 100 1.25% + 100 1.25% − 2 0.25% 100 = 2

In steady state, profits increase with size of balance sheet

Central bank profits in steady state


Central Bank

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Remittances have increased since the crisis

020

4060

8010

0B

illio

ns o

f U.S

. Dol

lars

2002 2004 2006 2008 2010 2012 2014

SOMA Net Income Remittances

SOMA Net Income and Federal ReserveRemittances to Treasury

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Interest on reserves goes up 𝑖2 = 4.25%

New asset purchases pay higher rate 𝑅2 = 5.25%

Old assets pay period 1 rate 𝑅1 = 1.25%

CB profits are now negative 𝜋2 = 100 5.25% + 100 1.25% − 200 4.25% = −2

Interest rates increase could lead to losses


Central Bank

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Interest on reserves goes back down 𝑖2 = 0.25%

New asset purchases pay higher rate 𝑅2 = 1.25%

Old assets pay period 1 rate 𝑅1 = 5.25%

CB Profits are now negative 𝜋2 = 100 5.25% + 100 1.25% − 200 0.25% = 6

Interest rate decrease would lead to high profits


Central Bank

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Challenge of normalization in the US is to raise market rates with a large supply of reserves

Our current set of tools is likely effective to raise market rates RRPs can reduce bank balance sheet costs TDF and RRPs can create scarcity if used in high enough

quantity Our framework suggests benefits of (fairly) large reserves

in the long run

Conclusion

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Questions?

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