The mechanics of the Federal Reserve’s balance sheet “runoff”
This blog post lists the three ways the Fed can reduce it balance sheet:
- Newly issued Treasury securities are purchased by banks – the Treasury repays the Fed for the maturing securities, which reduces the Treasury General Account (TGA) balance and the Treasury securities held by the Fed by the same amount. The size of the Fed’s balance sheet decreases with a reduction of Treasury securities on the asset side and reserves on the liability side;
- Newly issued Treasury securities are purchased by Money Market Funds (MMFs) – MMFs reduce their investments in the overnight reverse repo (ON RRP) facility to fund the purchase of the Treasury securities. ON RRP balances decline and the TGA balance increases by an equal amount.
- Banks and MMFs Purchase Newly Issued Securities.
In all three cases the Fed’s balance sheet decreases either through a reduction of reserves held by banks or through a reduction in ON RRP take-up or a combination of both.
The Fed’s Balance Sheet Runoff and the ON RRP Facility
By: Marco Cipriani, James Clouse, Lorie Logan, Antoine Martin, Will Riordan – Federal Reserve Bank of New York
The importance of reserve demand
In September 2019, US short-term money market rates spiked indicating that the Federal Reserve had reduced reserves to the point of creating a shortage of safe and liquid short-maturity assets. In this paper, Lopez-Salido and Vissing-Jorgensen argue that understanding reserve demand is central for assessing feasible balance sheet runoff.
We document that reserve demand is negatively related to the effective federal funds rate (EFFR)-interest on reserves (IOR) spread but the relation is unstable over the 2009m1-2022m1 period. We argue that deposits affect banks’ reserve demand and find a stable reserve demand curve once deposits are accounted for, with a tight negative relation emerging between the EFFR-IOR spread and “deposit-adjusted reserves”. Increasing amounts of deposits over the 2009m1-2022m1 period (driven partly by higher financial assets of households) imply that a scarcity of liquidity would now result much before reserves-to-GDP was reduced to 7% of GDP as in the policy normalization phase leading up to September 2019. We use our estimated reserve demand function to quantify more modest amounts of feasible reserve reduction.
Reserve Demand and Balance Sheet Run-off
Authors: David Lopez-Salido, Annette Vissing-Jorgensen
From: Federal Reserve Board
