In a previous post, we discussed the process in which the Federal Reserve makes decisions on monetary policy linked (here). As with legislation and other forms of policy, drafting and implementing it are two different things. One effective way of implementing policy is through a framework. This framework gives structure and direction to the implementation of policy and requires a certain context in which that implementation must take place. In the case of monetary policy there are two operating frameworks that depend on the context of the amount of bank reserves in the banking system. The Federal Reserve’s monetary policy regimes are rather self-explanatory as they are names limited reserves regime and the ample reserves regime. So, obviously they differ in the number of reserves held by banks, but they also differ in the monetary tools that are effectively used to effect short-term interest rates in their use.
Framework with limited reserves
Unfortunately, I cannot define exactly where the boundary between limited and ample reserves lies in a quantitative sense. Much like the Fed’s goal of maximum employment, the amount of reserve in the system that constitute a change between the regimes is purely qualitative in nature. The Fed loves moving targets. As the Fed defines it, a limited amount of reserves means there are “just enough to satisfy banks’ limited demand for reserves at the FOMC’s target federal funds rate.”[1] This reserve regime was dominant up until the Great Financial Crisis (2007-2009).
In order to keep just enough reserves in the system to satisfy bank demand, the fed was required to purchase or sell securities in the open market on a daily basis. From the perspective of the relationship between the Fed and one of its depository institutions, this purchase or sale is just an asset swap on the depository institution’s balance sheet. To increase the amount of reserves on the bank’s balance sheet, the Fed buys a security from them, taking their security and giving them bank reserves instead. A decrease in the bank’s reserves would just be the opposite of this where the fed sells the bank a security where the bank pays in bank reserves. It was through this injection or extraction of reserves from the banking system that the Fed influenced short-term interest rates. It is important to note that bank reserves are not currency in the typical sense. A good way to think of them is as a liquid asset held by eligible institutions that are denominated in dollars.
Framework with ample reserves
Below is a chart of the reserves held by depository institutions at the Fed where the vertical axis is in billions of dollars. This chart really shows the difference between the two regimes. When the Fed operated from a framework of limited reserves, the total number a reserves held by depository institutions looks minuscule compared to the amount now. The graph almost looks like it is zero-bound because after 2010 it becomes orders of magnitude larger than before 2007. Literally. In January 2008, there were $44.9 billion in bank reserves, however, at the end of 2021 there were $4187.9 billion. Talk about a hundred bagger.
Since there is not a defined quantitative boundary between the two frameworks, the Fed just ensures there are enough reserves in the system so that if they fluctuate widely, they will most likely not affect short-term interest rates.
Since there is no quantitative boundary that defines where the transition between a limited-reserves regime and an ample reserves regime takes place, we must study the behavior of the markets to see when we approach that mysterious boundary. As a measure of overnight funding cost in the Treasury repurchase agreement market, the SOFR rate provides some insight into the liquidity of the system at a given time. The reason I bring this up is because it has been proposed by some, and by some Fed staff as well, that this spike in the SOFR rate was due to not enough bank reserves in the system to provide liquidity, therefore showing that the number of reserves from the perspective of the repo market participants was no longer considered “ample” enough to lend to some counterparties. This could hint at where this boundary between regimes may lie, in this case around $1.5 trillion. Keep in mind this is one perspective. It has also been proposed that this spike could have been due to a lack of collateral, in this case treasuries.
Also, after this spike in SOFR rates in September, the Fed announced the next month (October 2019) that they plan to stay within this monetary policy framework of ample reserves. So at least we will have some history to look back upon to see how this framework performs.
Fed tools for the ample reserves framework
Within this monetary policy framework with an ample amount of bank reserves, there is no use for the Fed to trade securities on the open market to influence short-term interest rates. Therefore, they must influence short-term rates through a different medium. Today, the Fed uses two of their administered rates, Interest of reserve balances (IORB) and the overnight reverse repo offering rate (ON RRP). These two rates are used to attempt to anchor short-term rates by creating a floor for them.
Let us think about this for a second. So, the Federal Reserve is the counterparty with the least amount of default risk since they can just create the currency their debts are denominated in. That being said, if you were one of their depository institutions, you would most likely be content with charging them the lowest interest rate compared to any other counterparty. In other words, all other counterparties will be charged a higher interest rate, meaning the rate the Fed pays is the floor for interest rates, at least that are charged by its depository institutions. In the case of IORB, the depository institution gets paid for just leaving their bank reserves in their reserve account. If the institution needs collateral, typically in the form treasury bills as of this writing, then they will buy the securities from the fed with a promise to repurchase them at a later date with some interest.
As a sidenote, on of the things that confused me at first with these rates is how ON RRP helps set the floor for overnight funding rates. My thinking was that because it is the banks paying the interest upon repurchase, it would therefore set a ceiling for the rates they would pay for funding. However, ON RRP is more for financial institutions that are not eligible for IORB, meaning they cannot have bank reserves. In essence, ON RRP provides these bank reserveless institutions an alternative “risk-free” investment option. I put “risk-free” in quotes because that is what the New York Fed calls it, but I have my doubts that it is actually free of risk. Ultimately, the ceiling for the Fed funds target range comes from the discount rate the Fed charges banks for the loans made through the Fed’s discount window. Below is the link to the New York Fed’s webpage that helped me understand this sidenote.
Final words on the Federal Reserve’s monetary policy regime
Just as political parties have a platform from which they create their policy, the Fed has a framework on which they base their monetary policy. This framework depends on the amount of bank reserves in the banking system as this changes the tools with which the Fed can influence short-term interest rates. If there are a limited amount of reserves in the system, simply by changing the amount of reserve the Fed can influence short-term rates (Limited-reserve framework). On the other hand, if there is an ample amount of reserves in the system, significant fluctuations in their amount will not, by itself, influence rates. Therefore, the Fed must resort to administered rates such as Interest on Reserve Balances and the Overnight Reverse Repurchase agreement offering rate to set a floor for interest rates according to their Fed funds target range. Once you understand the Federal reserve’s monetary policy regime, you can understand the tools they use to a greater extent because the regime itself defines which tools would be useful.
To your wealth and future,
James Forsythe
For a YouTube video with more explanation and commentary
References for the Federal Reserve’s monetary policy regime
[1] The Fed Explained: What the Central Bank Does, Federal Reserve System Publication, pg. 39
[2] G. Afonso, et al. “The Market Events of Mid-September 2019”, Federal Reserve Bank of New York Staff Reports
