What We Wanted We Got: A Debate on the Fed’s Balance Sheet

A big question addressed at this year’s annual Hoover monetary conference was “The Future of the Central Bank Balance Sheet,” including the amount of reserve balances that banks hold at the Fed. The issue is one that “the [Federal Reserve] Board and the FOMC are in the process of observing and evaluating” as Vice-Chair Randy Quarles put it at the conference.

There are two basic approaches to the question. One is for the Fed to aim for a supply of reserve balances in which the interest rate is determined by the demand and supply of reserves—in other words, by market forces.  Sometimes called the corridor approach, it’s what Fed used for decades before financial crisis. The second approach is for the Fed to aim at a supply of reserves well above quantity demanded, and then set the interest rate through interest on excess reserves.  This method is sometimes called a floor system.

I’ve written in favor of the first approach which implies a much lower level of reserves. But it’s a crucial decision, and the Fed needs a good open debate of different views. That is what we got at the conference with a panel of Fed officials, market participants, and academics:

This is a topic where any short summary will miss the mark, and there’s no substitute for reading the the fascinating evidence-based papers, some with really catchy titles.

Lorie Logan, from the NY Fed trading desk, argued for the second view, emphasizing that markets would be less volatile if the Fed sticks to a floor system. Fisher, who used to run the NY Fed trading desk, disagreed, saying that operational considerations for the staying Big are not convincing, and that the rationale is completely orthogonal to the case made of going Big in the first place. Bill Nelson, who is familiar with operational considerations from his time at the Board, argued in favor of the first approach, and Mickey Levy noted the economic and political risks of maintaining an “out-sized balance sheet,” and concluded that “The Fed’s exposure to Congress’s dysfunctional budget and fiscal policy making in the face of mounting government debt and debt service costs is particularly concerning.”

I understand that a Fed decision is likely in the next year. So let the debate go on.

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