Download Policy Implementation with a Large Central Bank Balance Sheet

Policy Implementation with a Large Central
Bank Balance Sheet
Antoine Martin
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
Outline
 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?
2
Monetary policy implementation before 2008
Interest rate
DW rate
Target rate
Demand for reserves
Required
reserves
0
Target
supply
Reserve
balance
3
Pre-Crisis Operational Framework
 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)
4
Framework was similar to a “corridor” system
Interest rate
DW rate
Demand for reserves
Target rate
IOER
Required
reserves
0
Target
supply
Reserve
balances
5
Outline
 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?
6
The crisis lead to a huge increase in reserves
Reserve Balances with Federal Reserve Banks
3000
(Billions of Dollars)
2500
2000
1500
1000
500
0
2007
2008
2008
2009
2011
2012
2012
2013
2015
7
Monetary policy implementation since 2008
Interest rate
Supply of reserves
is not linked to
target rate
DW rate
IOER
0
Supply
Reserve
balance
8
Interest on excess reserves (IOER)
 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
9
Current Framework
 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
10
Reserves and Money Market Rates
GC Treasury Overnight, Effective Fed Funds, IOER,
Eurodollar, and Total Reserves
0
Rate (Percent)
.1
.2
.3
-3000-2500-2000-1500-1000
Reserve Balances (Billions)
01 Jan 2010 - 30 Aug 2015
Jan 10
Oct 10
Aug 11
Jun 12 Apr 13
Date
Jan 14
Nov 14
GC Treasury Overnight
Eurodollar (ED)
Fed Funds (FF)
IOER
Sep 15
- (Total Reserves)
Sources: FRED, Federal Reserve Economic Data, from the Federal Reserve Bank of St. Louis,
Bloomberg, and Federal Reserve Data Releases, H15
11
The “leaky floor”
Interest rate
Supply of reserves
is not linked to
target rate
DW rate
IOER
0
Supply
Reserve
balance
12
Why are market rates below the IOER?
 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
13
Why doesn’t competition lift market rates
 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
14
Why are banks holding excess reserves?
 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)
15
Before 2008: Low amount of reserves
 Suppose there are two banks, A and B
 Balance sheets in normal times:
Bank A
Reserves
Loans
Due from
Bank B
Securities

10
50
40
10
Deposits
Capital
Bank B
100
10
Reserves
Loans
Securities
10
130
10
Deposits
Due to
Bank A
Capital
100
40
10
Note: Interbank lending promotes the efficient allocation of
resources
16
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
Bank B
Bank A
Reserves
Loans
Due from
Bank B
Securities
50
50
0
10
Deposits
Capital
100
10
Reserves
Loans
Securities
10
90
10
Deposits
Due to
Bank A
Capital
100
0
10
17
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
Bank A
Reserves
Loans
Securities
50
50
10
Deposits
Capital
Bank B
100
10
Reserves
Loans
Securities
10
130
10
Deposits
Due to
CB
100
Capital
10
40

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
18
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
Bank A
Bank B
Reserves
Loans
50
70
Deposits
120
Reserves
Loans
10
130
Securities
10
Capital
10
Securities
10
Deposits
Due to CB
Capital
100
40
10
No change in reserve positions!
19
 Now suppose Firm X buys $20 in equipment from Firm Y
 Firm Y holds its account at Bank B
Bank B
Bank A
Reserves
Loans
30
70
Deposits
100
Reserves
Loans
30
130
Securities
10
Capital
10
Securities
10

Capital
120
40
10
Reserves (and deposits) are transferred to Bank B


Deposits
Due to CB
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
20
Outline
 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?
21
Monetary policy normalization
 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?
22
Exit and Patching the Leaks
 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?
23
A framework
 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
24
Key Frictions
 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
25
A Simple Economy
 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
26
Two polar cases
 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
27
New Federal Reserve Tools
 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
28
Overnight RRP
 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?
29
TDF
 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?
30
How do the tools affect the frictions?
 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)
31
Do we have the tools to raise rates?
 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
32
How should we use our tools?
 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
33
Outline
 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?
34
Implications for long-term framework
 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
35
One option: A “floor” system
Interest rate
DW rate
IOER
Supply of reserves
is still not linked to
target rate
0
Supply
reserve
balance
36
Is it costly to have a large supply of reserves?
 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
Central Bank
New Assets
Old Assets
100
100
Reserves
200
 𝑅𝑡 = 𝑖𝑡 + 1
 Central Bank Profits:
𝜋𝑡 = 100(𝑅𝑡 + 𝑅𝑡−1 − 2𝑖𝑡 )
37
Central bank profits in steady state
 Interest on reserves is Low
 𝑖0 = 𝑖1 = 0.25%
Central Bank
New Assets
Old Assets
100
100
Reserves
200
 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
38
Remittances have increased since the crisis
0
Billions of U.S. Dollars
20
40
60
80
100
SOMA Net Income and Federal Reserve
Remittances to Treasury
2002
2004
2006
2008
SOMA Net Income
2010
2012
2014
Remittances
39
Interest rates increase could lead to losses
 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%
Central Bank
New Assets
Old Assets
100
100
Reserves
200
 CB profits are now negative
 𝜋2 = 100 5.25% + 100 1.25% − 200 4.25% = −2
40
Interest rate decrease would lead to high profits
 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%
Central Bank
New Assets
Old Assets
100
100
Reserves
200
 CB Profits are now negative
 𝜋2 = 100 5.25% + 100 1.25% − 200 0.25% = 6
41
Conclusion
 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
42
Questions?
43