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Finance and Economics Discussion Series
Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C.
Monetary Policy 101: A Primer on the Fed’s Changing Approach
to Policy Implementation
Jane E. Ihrig, Ellen E. Meade, and Gretchen C. Weinbach
Please cite this paper as: Jane E. Ihrig, Ellen E. Meade, and Gretchen C. Weinbach (2015). “Monetary Policy 101: A Primer on the Fed’s Changing Approach to Policy Implementation,” Finance and Economics Discussion Series 2015-047. Washington: Board of Governors of the Federal Reserve System, http://dx.doi.org/10.17016/FEDS.2015.047. NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.
Monetary Policy 101:
A Primer on the Fed’s Changing Approach to Policy Implementation
Jane Ihrig, Ellen E. Meade, and Gretchen C. Weinbach*
June 30, 2015
Abstract
The Federal Reserve conducts monetary policy in order to achieve its statutory mandate of maximum employment, stable prices, and moderate long-term interest rates as prescribed by the Congress and laid out in the Federal Reserve Act. For many years prior to the financial crisis, the FOMC set a target for the federal funds rate and achieved that target through small purchases and sales of securities in the open market. In the aftermath of the financial crisis, with a superabundant level of reserve balances in the banking system having been created as a result of the Federal Reserve’s large scale asset purchase programs, this approach to implementing monetary policy will no longer work. This paper provides a primer on the Fed’s implementation of monetary policy. We use the standard textbook model to illustrate why the approach used by the Federal Reserve before the financial crisis to keep the federal funds rate near the FOMC’s target will not work in current circumstances, and explain the approach that the Committee intends to use instead when it decides to begin raising short-term interest rates.
Keywords: Federal Reserve, FOMC, monetary policy implementation, monetary policy tools, monetary policy normalization, liftoff
JEL Classifications: E58, E52, E
- Economists in the Division of Monetary Affairs at the Board of Governors of the Federal Reserve System. We thank Miguel Acosta, Jim Clouse, Melanie Josselyn, Joe Kachovec, Steve Meyer, Ben Miller, and Bill Nelson for comments. Melanie Josselyn and Joe Kachovec provided excellent research assistance. The views expressed here are those of the authors and do not necessarily reflect the views of other members of the research staff, the Board of Governors of the Federal Reserve System, or the Federal Reserve System.
Box 1: How do reserve requirements affect reserve balances?
The Federal Reserve Act (as amended by the Monetary Control Act of 1980) and the International Banking Act of 1978 impose reserve requirements on most deposit-taking institutions in the United States, requiring that they hold a certain fraction of their deposits in reserve. In particular, all depository institutions—commercial banks, savings banks, thrift institutions, and credit unions—as well as most U.S. branches and agencies of foreign banks (hereafter “banks,” for simplicity) are assessed reserve requirements against certain deposit liabilities. Banks are required to satisfy their reserve requirements in the form of vault cash, which they hold primarily to meet the liquidity needs of their customers and, if the quantity of vault cash held is insufficient, also in the form of a balance maintained at the Federal Reserve. The balances banks maintain at the Federal Reserve that are necessary for meeting reserve requirements are called required reserve balances; any reserve balances held in excess of what is necessary to meet reserve requirements are termed excess balances.^2
Prior to the financial crisis, many banks in the United States satisfied their entire reserve requirement with vault cash, though about 900 banks did not and so also needed to maintain reserve balances at the Fed to satisfy their requirements. The total amount of reserve balances in the banking system hovered around $15 billion, with excess balances making up less than $2 billion of this total. However, as discussed in greater detail in section 2 and shown in the figure below, reserve balances have grown tremendously since the financial crisis. In late December 2014, reserve balances stood at more than $2.6 trillion and have remained in that neighborhood since then, with excess balances making up all but about $90 billion of this total.
Total reserve balances
(^2) In practice, banks meet their required reserve balances (also referred to as “reserve balance requirements”) with some leeway. A penalty-free band is used to create a range on both sides of the required reserve balance within which a bank needs to maintain its average balance over a given period. For more information on the calculation and maintenance of reserve requirements, see the Federal Reserve Board’s Reserve Maintenance Manual and web page on Reserve Requirements. Data on reserve balances are published weekly on the H.3 Statistical Release.
Figure 1 presents the standard demand and supply framework for reserve balances shown in many Money and Banking textbooks. Demand is downward sloping because the higher is the opportunity cost of holding reserve balances, the lower is the demand for them. Conversely, as the price of overnight borrowing falls, banks are generally inclined to borrow more in order to satisfy their reserve requirements and also possibly to leave themselves with a bit of extra balances to protect against unexpected outflows that can cause reserve balance deficiencies, for which banks are charged a penalty. In theory, the price, or rate of interest, that an institution is willing to pay to borrow funds overnight—that is, the federal funds rate—should be capped at the Federal Reserve’s primary credit rate. The primary credit rate is the interest rate that the Fed charges banks to borrow overnight from its primary credit program (part of the Fed’s discount window), which provides banks with a source of back-up funding at an interest rate that is well above the Fed’s target federal funds rate. Thus, a bank would be unlikely to borrow in the federal funds market at a rate above the primary credit rate because it could instead obtain the funding it needs more cheaply by borrowing directly from the Fed.^3
Figure 1 Banks’ demand for and the Fed’s supply of reserve balances
The supply curve for reserve balances is vertical because the Fed is a monopolistic supplier of reserves; the supply curve shifts to the right or left when the Fed adds or subtracts reserves from the banking system using OMOs.^4 The intersection of the demand and the supply curves occurs at the market federal funds rate.
(^3) Although, in theory, banks should be unwilling to pay more than the primary credit rate for overnight funding, they sometimes do. Transactions costs as well as reputation effects (termed “stigma”) associated with borrowing from the Fed lead some banks to borrow from other institutions in the federal funds market at interest rates that exceed the primary credit rate. Data on banks’ aggregate borrowings from the Fed are published weekly on the H.3 Statistical Release. For more information on the Fed’s discount window programs, see Purposes and Functions (2005). (^4) Note that when banks trade existing reserve balances among themselves in the federal funds market, that trading leaves the aggregate amount of reserve balances unchanged.
equal, once the repurchase agreement was concluded, with the security having made its round-trip back to the private sector, the supply curve for reserve balances would also be back where it started.
The Fed could also drain reserve balances temporarily if it needed to do so using a reverse repurchase agreement, also known as a “reverse repo” or “RRP.” In this type of OMO, illustrated in the figure below, the Desk would sell a security to the private sector, a transaction that would initially result in a decline in the quantity of reserve balances in the banking system, shifting the supply curve to the left. As with a repo transaction, this transaction would include a second step in which the transaction is unwound—the Desk would repurchase the security at a specified price at an agreed-upon time in the future and return the funds it had been holding, leaving reserve balances back where they started. In either a repo or reverse repo transaction, the difference between the sale price and the repurchase price of the security, together with the length of time between the sale and purchase steps of the transaction, implies a rate of interest earned by the party that purchased the security and loaned the funds.^8
Illustration of an RRP transaction
As shown in Figure 2, the federal funds rate and other short-term market interest rates continue to move together. This reflects, in part, the fact that many of the same financial institutions are active participants in the market for various money market instruments, including federal funds, Eurodollar, and repo markets.^9 In particular, as shown in Table 1, banks
(^8) Technically, when the Fed buys a security in a repo transaction or sells a security in a reverse repo transaction the size of its securities holdings is unchanged, in accordance with generally accepted accounting principles. However, these transactions do temporarily change the composition of the Fed’s balance sheet while the trades are outstanding. For example, a reverse repo transaction shifts funds out of reserve balances and into reverse repos, resulting in a compositional change in the Fed’s liabilities and no change to its assets. For more information, see the Appendix and the FAQ on the Federal Reserve Bank of New York’s website. (^9) A Eurodollar transaction is very similar to a federal funds transaction—both are unsecured trades. While federal funds are U.S.-dollar deposits at U.S. banks, Eurodollars are U.S.-dollar deposits at a bank outside of the United States. A repo transaction, on the other hand, is a secured trade (details are provided in Box 2).
are active borrowers in all three of these money markets, and while the lenders vary a bit across the markets, there is also notable overlap. All in all, arbitrage generally works well to keep money market rates highly correlated.
Figure 2 Overnight market interest rates
Source: For Eurodollar, Bloomberg; for Treasury GCF Repo, Depository Trust & Clearing Corporation (DTCC); for Federal Funds, Federal Reserve Bank of New York; for Interest on Excess Reserves, Federal Reserve Board.
Table 1 Major borrowers and lenders of cash in money markets
Federal funds Eurodollar (^) Reverse RepoRepo and
Borrowers of cash Banks Banks (^) Securities dealersBanks
Lenders of cash
Banks Securities dealers GSEs*
Money market funds Other financial firms Nonfinancial firms
Money market funds Securities dealers GSEs* Hedge funds
- GSEs are government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBs).
Moreover, changes in the level of short-term interest rates over time have generally been transmitted to other, longer-term interest rates as well, including those commonly faced by businesses and households, thereby ultimately influencing the pace of economic activity. As conditions in the economy changed over time, the Committee adjusted monetary policy
Figure 4 A simplified Federal Reserve balance sheet: Before and after the financial crisis (billions of dollars)
Before: August 8, 2007
After: December 24, 2014 Assets Liabilities Assets Liabilities
Securities 791 Reserve balances 14 Securities 4,247 Reserve balances
Other assets 78 Currency^777
Other assets 262 Currency^ 1, Other 45 Other 548 Capital 34 Capital 57 Total 869 Total 869 Total 4,509 Total 4,
government agencies.^13 With short-term interest rates already near zero, the purpose of these operations was to put downward pressure on longer-term interest rates in the economy (see Figure 3)—the purchases reduced the available supply of securities in the market, leading to an increase in the prices of these securities and a reduction in their yields.^14
In order to maintain these effects on yields, the Fed has been keeping its securities holdings steady by reinvesting principal payments on agency debt and agency MBS and by rolling over Treasury securities as they mature. As a result of these LSAPs and the FOMC’s securities reinvestment policy, as illustrated in the right panel of Figure 4, the Fed’s securities holdings rose to nearly 5½ times their pre-crisis level, with agency MBS representing about 40 percent of the securities portfolio.^15 In addition, reserve balances became the largest liability, amounting to $2.6 trillion. As we will explain shortly, in an environment with a superabundant level of reserves, the Federal Reserve can no longer rely on small changes in the supply of aggregate reserves to adjust the level of the federal funds rate.
Another important factor affecting the federal funds market and thus the implementation of monetary policy going forward is the introduction of interest payments on reserve balances. Since October 2008, the Federal Reserve has paid interest on the balances that banks maintain
(^13) In addition, the Fed conducted a maturity extension program where it sold $667 billion in shorter-dated Treasury securities and purchased the same amount of longer-dated Treasury securities. More details regarding all the purchase programs may be found on the Board’s website. (^14) The LSAPs also helped to support mortgage markets. For more information on LSAPs, see the Board’s website. (^15) The increase in securities holdings on the Fed’s balance sheet between August 2007 and December 2014 is less than total securities purchased because the FOMC did not implement its reinvestment policy until August 2010.
to satisfy their reserve requirements and on banks’ excess balances.^16 Since the Fed began paying interest on reserves, the market federal funds rate has generally been below the IOER rate. This situation has arisen because, in addition to banks not needing to borrow actively from each other because of the high quantity of reserves in the banking system, there are also nonbank lenders in the federal funds market who, by law, are not eligible to earn the IOER rate on the balances they keep at the Fed (see the first column of table 1). Thus, those nonbanks have an incentive to lend reserves at any rate above zero while banks have an incentive to purchase federal funds at rates below the IOER rate in order to earn the spread between the market rate at which they purchased the funds and the IOER rate they earn from the Fed on those funds. This is an example of an arbitrage transaction, and we discuss the role of arbitrage in more detail below.
Figure 5 compares the market for reserve balances before the financial crisis—repeating Figure 1 in panel (a), on the left—with the current environment, depicted by panel (b) on the right. There are two key differences between the panels. The first is that with the Fed paying interest on reserves, the lower portion of banks’ demand curve flattens out near the IOER rate, reflecting the arbitrage activity just described. The second difference is that the supply curve in panel (b) is shown far to the right on the x-axis, representing the superabundant level of reserves in the banking system. As a consequence, the supply curve now intersects the demand curve on the flat portion of the demand curve. The FOMC has said that when economic conditions and the economic outlook warrant a less accommodative monetary policy, it will raise its target range for the federal funds rate.^17 But with the supply curve in its current position, the steps that the FOMC traditionally took to put upward pressure on market interest rates—announcing a higher target level for the federal funds rate and being prepared to conduct an OMO of the sort that the Fed has traditionally done to ensure the federal funds rate hit the FOMC’s new target level (that is, possibly selling a small amount of securities into the market and draining an equally small amount of reserves)—will no longer suffice. The key question is, when the FOMC decides it is time to begin removing monetary policy accommodation by raising its target range for the federal funds rate, how will the desired increase in short-term interest rates be accomplished?
(^16) The Financial Services Regulatory Relief Act of 2006 authorized interest payments on reserve balances beginning in 2011, and during the financial crisis, the Emergency Economic Stabilization Act of 2008 advanced the effective date of this authority to October 2008. The Federal Reserve pays interest on reserve balances that banks hold to meet reserve requirements and on their excess balances. These rates are currently the same, although they could be set at different levels. (^17) The FOMC outlined its plans for policy normalization in its Policy Normalization Principles and Plans that it issued to the public after its September 2014 meeting. The FOMC provided additional detail regarding its plans in the minutes of the March 2015 meeting. These FOMC communications are discussed in section 5.
money below the rate earned on the policy tool and put upward pressure on the lowest interest rates in money markets.
- Increase reserve scarcity: Use of the policy tool can increase reserve scarcity by draining reserve balances and moving the level of aggregate reserves closer to its traditional position. If the aggregate level of reserve balances were reduced sufficiently, banks would need to resume borrowing federal funds to meet their demand for reserve balances, leading them to put upward pressure on the market federal funds rate.
Table 2 summarizes the channels through which each of the policy tools, described in turn below, aims to increase short-term interest rates. Overall, each of the policy tools is generally designed to do one or both of the following things: (1) Provide an investment option that acts as a reservation rate that market participants will factor into their investment decisions; (2) reduce the quantity of reserve balances in the banking system.
Table 2 The channels through which the policy tools put upward pressure on rates
Policy tools (described below)
Encourage arbitrage
Increased scope of influence
Increase reserve scarcity Increase IOER rate Offer RRPs (overnight or term) Offer term deposits Reduce Fed’s securities holdings Increase reserve requirements
4.1 Rate of interest on excess reserve balances
The FOMC has indicated that the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the rate of interest on excess reserve balances or the IOER rate.^19 The IOER rate encourages arbitrage—it acts as a reservation rate for banks as they make their money market investment decisions. As described above, all else equal, an increase in the IOER rate would be expected to put upward pressure on the federal
(^19) Note that the Federal Reserve has designated two rates of interest on reserve balances, one rate for required reserve balances (the IORR rate) and a separate rate for excess reserve balances (the IOER rate); for simplicity and given the predominance of excess balances, we refer to the IOER rate throughout this piece. For a time in 2008, both the IORR and IOER rates were determined by a formula linked to the federal funds rate and set at different levels; in December 2008, the FOMC reduced the federal funds rate target to a range of 0 to 25 basis points and set the IORR and IOER rates equal to 25 basis points.
funds rate because banks would have an incentive to borrow in the federal funds market at rates below the IOER rate and place those balances at the Fed to earn the IOER rate.^20 Similarly, other money market rates should increase as banks arbitrage between holding excess reserve balances and these alternative money market instruments.
Of course, banks need to be willing and able to actively perform this arbitrage for these effects to be realized. To date, banks have been willing to arbitrage the IOER rate so that, as shown in Figure 2, the federal funds rate has been highly correlated with other money market rates. But, as also illustrated in the figure, these money market rates have remained below the IOER rate because, as noted above and in Table 1, banks are not the only participants in the federal funds market. Government-sponsored enterprises (GSEs), institutions that also hold reserve accounts at the Fed but are not eligible to earn interest on those balances, also participate in the federal funds market. These institutions are willing to lend out federal funds at rates that are relatively low because their return on balances held at the Fed is zero.^21 Moreover, because reserve balances are superabundant among banks, nearly all of the federal funds trading reflects borrowing by banks from non-IOER-earning institutions, at relatively low rates, to engage in such arbitrage activity. Next we discuss a tool that was designed to support short-term interest rates from below.
4.2 Overnight RRPs
The FOMC has indicated that, when the time comes to begin to raise the target federal funds rate, it intends to use an overnight reverse repurchase agreement facility as needed to help keep the federal funds rate within its target range. Box 2 provided a description of how the Fed conducted RRP transactions prior to the financial crisis, and noted that such transactions were conducted for the purposes of causing a temporary decline in reserve balances in order to put upward pressure on the federal funds rate. At that time, the Fed occasionally conducted relatively small-dollar amounts of overnight RRPs or “ON RRPs” with a group of institutions known as “primary dealers.”^22 Today, the Fed is routinely conducting ON RRPs in the form of test exercises; these ON RRPs have three key operational differences relative to their use in monetary policy operations before the financial crisis. The first difference is that ON RRPs have been offered on a daily basis with an offering rate that is pre-announced and can act as a reservation rate, encouraging arbitrage in money markets. In particular, the offering rate is the maximum interest rate the Fed is willing to pay in the
(^20) In conducting this arbitrage activity, reserve balances are shuffled among banks; this activity will not bring about a change in the aggregate quantity of reserve balances in the banking system (see the Appendix for more detail). (^21) See Goodfriend (2015). (^22) A primary dealer makes markets in Treasury securities; that is, it buys (sells) Treasury securities directly from (to) the government with the intention of acting as the “middleman” between the government and market participants in the private sector.
The Fed’s testing of ON RRP operations has demonstrated that these operations can set a soft floor under the level of the federal funds rate and other short-term market interest rates, as long as market participants are confident that the aggregate cap on ON RRPs is large enough to meet demand.
If the Fed wanted to increase the scarcity of reserves in the banking system, it could set the offering amount on its ON RRP operation relatively high, and possibly also adjust the offering rate, to encourage demand for these operations. However, the FOMC has discussed concerns associated with having a persistently large ON RRP program, a topic to which we will return in section 5. Thus, the role that ON RRPs may play in increasing reserve scarcity over time is likely to be limited. Instead, the Fed could use other tools, such as term RRPs or term deposits to increase reserve scarcity, and we discuss these next.
Box 3: How does the Fed determine take-up at each ON RRP operation?
Financial institutions that are eligible to engage in ON RRP operations with the Fed compare the Fed’s offering rate on ON RRPs to market interest rates on similar assets and choose how many securities to bid for—and thus how many dollars to place with the Fed—at each operation. During the testing phase of the ON RRP exercises, the Fed has typically allowed eligible institutions to bid up to $30 billion at each operation. How does the Fed decide which bids to accept? The answer depends on whether the Fed has capped the ON RRP operation in aggregate size or not, and if so, whether the total amount bid is above or below the cap. If an operation is not capped in aggregate or if the total amount bid is less than the cap, all bids are accepted at the Fed’s offering rate. But if the operation is capped and the total amount bid exceeds the cap, an auction process is used to allocate the available amount of the operation. Next we walk through these two cases.
First, suppose that the Fed offers ON RRPs in an unlimited aggregate amount. Further, let’s suppose, as has typically been the case during the testing phase of the ON RRP exercises, that the Fed’s offering rate is 5 basis points. Also assume, as illustrated in the table below, that five institutions submit bids that range between $5 and $15 billion for a total of $58 billion. With no capacity constraints on the operation, all counterparties would be awarded their bid amount at the operation’s offering rate of 5 basis points. What this means is that these institutions would place $58 billion at the Fed overnight, and the Fed would return the funds with interest the next day. (See the Appendix for a full analysis of an ON RRP transaction, including its effects on reserve balances and the Fed’s securities holdings.)
Now suppose instead that the Fed wanted to limit the size of this operation to $40 billion in aggregate— that is, each institution could still bid up to $30 billion, but the Fed wanted to award only $40 billion in total. The Fed could do this by announcing ahead of time that there will be an aggregate cap of $
Sample bids for an uncapped ON RRP operation
Institution Bid amount ($ billions) 1 10 2 5 3 20 4 8 5 15
billion on the operation. In this case, the Fed would not only ask institutions to submit bid amounts, but also bid interest rates (third column in the table below). The FOMC would sort the bids from the lowest bid interest rate to the highest bid interest rate, and fill each requested bid amount until the $40 billion in take-up had been reached, prorating any bids at the highest bid rate needed to achieve $40 billion. In this case, institutions 1, 2, and 3 would receive their full bid amounts of $10, $5, and $20 billion, for a total of $35 billion. To award the remaining $5 billion, institution 4’s bid amount would be reduced from $8 billion to $5 billion. (If more than one institution had bid 4 basis points in this example, the remaining $5 billion would be prorated among those institutions according to the share of the total amount bid at 4 basis points that is accounted for by each institution). Because the maximum operation size of $40 billion was met by the Fed paying 4 basis points, all amounts would be awarded at 4 basis points, referred to as the “stop-out rate.”
Sample bids for a capped ON RRP operation
Institution Bid amount ($ billions) (basis points)^ Bid rate 1 10 2 2 5 3 3 20 3 4 8 4 5 15 5
Both types of operation limits—an institution-level cap and an aggregate cap—have been used during the testing phase of ON RRP operations, with the institution-level cap typically set at $30 billion and the aggregate cap set at $300 billion. The Federal Reserve has been reporting the results of its daily ON RRP test operations, including the bid amounts submitted and accepted, as well as the high, low, and awarded bid rates.^24 On September 30, 2014, for example, demand for Fed ON RRPs was more than $400 billion. The operation’s aggregate cap was $300 billion, resulting in some counterparties having their bids prorated or declined, and the resulting stop-out rate was 0 basis points.
(^24) The results of the most recent ON RRP operation may be found on the Federal Reserve Bank of New York’s website.
scarcity. The TDF also encourages arbitrage as banks compare the yield the Fed offers on a term deposit with other investments of a similar term.
The Fed has been testing the functionality of the TDF since June 2010. During these operational tests, two types of term deposit operations have been conducted. In the first type, the Fed offers a given dollar amount of term deposits; banks then bid for the size of the deposit they want and specify the interest rate on the deposit. The Fed accepts bids beginning with the lowest bid rate and proceeding to higher bid rates until the total offered amount is exhausted. When this type of term deposit operation is conducted, all banks receive an interest rate that is identical to the rate paid to the last bank whose bid was accepted—that is, all banks receive the highest bid rate. In the second type of term deposit operation, the Fed sets an offering rate and allows banks to deposit the amount of funds they desire, up to a predetermined maximum.
In its test operations, the Fed has varied some features, including the length of the term, the offering rate, and whether banks are permitted to withdraw their deposits prior to the end of the term, subject to a penalty.^27 The latter feature has proven to be particularly attractive to banks in making their cash management decisions. During testing in February 2015, term deposits outstanding grew to about $400 billion on the Fed’s balance sheet.
4.5 Reduce the Fed’s securities holdings
As noted above, the Federal Reserve purchased large quantities of securities during its large- scale asset purchase programs and it has been reinvesting any maturing or prepaying securities in order to maintain its holdings of longer-term securities at sizable levels and help maintain accommodative financial conditions. The FOMC has said that, at some point after it begins to increase the target range for the federal funds rate, it will reduce the Federal Reserve's securities holdings in a gradual and predictable manner, primarily by ceasing to reinvest repayments of principal on securities held by the Federal Reserve.
Ending reinvestments would cause the Fed’s holdings of securities to decline when either a Treasury security matures or an agency MBS prepays. The pace at which this would occur is driven in part by the maturity dates of the Fed’s holdings of Treasury and agency securities, which are known for certain, and also by the pace at which agency MBS might prepay, which can only be estimated. Prepayment of agency MBS occurs, for example, when households pay off some or all of a mortgage balance early because they refinance their original mortgage with a lower available mortgage rate, pay off their mortgage in full when they sell a house to move, or pay down a portion of their mortgage to reduce the level of their debt.
As discussed below in Box 4, the Fed’s securities holdings could decline noticeably once the FOMC decides to end reinvestments. Doing so would naturally shift the reserve supply curve
(^27) Results of all term deposit operations can be found on the Federal Reserve Board’s website.
gradually to the left, increasing reserve scarcity. Of course, it would take a number of years for the quantity of securities to decline sufficiently to create a meaningful inward shift in the supply curve—that is, one that would be effective in helping to put upward pressure on the federal funds rate.
Box 4: What would stopping reinvestments imply for the Fed’s securities holdings?
As of late December 2014, the Federal Reserve held a total of $4.2 trillion of securities, of which about $2.5 trillion were Treasury securities, $1.7 trillion were agency MBS, and about $39 billion were agency debt. The Federal Reserve Bank of New York regularly reports details regarding the Fed’s securities portfolio, including the Committee on Uniform Securities Identification Procedures (CUSIP) number of each Treasury security and agency MBS the Fed holds in its portfolio.^28
If the FOMC were to end its policy of reinvesting its securities holdings at some point over the near term, the Fed’s holdings of securities would decline noticeably. As shown in the table below, nearly $700 billion of securities would mature or roll off of the Fed’s portfolio in 2016 and 2017 taken together, comprised of about $410 billion of Treasury securities and an estimated $285 billion of agency MBS.
Absent reinvestment, how many securities would mature or roll off in 2016-17? (billions of dollars)
Date Treasury securities Agency MBS* Total
2016: H1 129 85 214 2016: H2 86 75 161 2017: H1 103 65 168
2017: H2 91 60 151
Cumulative 409 285 694
- Using actual holdings of securities as of December 24, 2014, and projected agency MBS prepayments based on the model in Carpenter et al. (2015) along with Blue Chip interest rate projections at that time.
The Fed could also sell securities in order to reduce its holdings, which would cause reserve balances to decline commensurately. However, the FOMC has indicated that it will raise interest rates by taking actions to move the federal funds rate into the new target range rather than through actions to adjust the size or composition of the Fed’s balance sheet. In particular, in section 5 we discuss why securities sales are not a feature of the FOMC’s chosen approach.
(^28) These details may be found on the Federal Reserve Bank of New York’s website.
