For release on delivery
7:15 p.m. EST
February 6, 2020
The Economic Outlook, Monetary Policy, and the Demand for Reserves
Remarks by
Randal K. Quarles
Vice Chair for Supervision
Board of Governors of the Federal Reserve System
at the
Money Marketeers of New York University
New York, New York
February 6, 2020
I would like to thank the organizers for the opportunity to speak to you today. My
plan is to address some topical and important issues, some of which are quite technical but
technicalities that I think can have significant consequences.1 After providing my thoughts
on where the economy and monetary policy are now, I will turn to what we can expect
from monetary policy in the years to come.
Changes in the economic environment since the financial crisis, including an
apparent decline in the equilibrium interest rate, have complicated the conduct of monetary
policy as we work to achieve our dual mandate of maximum employment and stable prices.
The Federal Open Market Committee (FOMC) is currently undertaking a review of its
monetary policy strategy, tools, and communication practices to make sure we are best
positioned to confront the challenges ahead. Since the Committee is still actively
discussing the review, I have no intention of front-running the results. Instead, I would like
to address a separate but not unrelated topic, the interaction of bank supervision and
regulation with monetary policy, and how supervision and regulation might work to make
monetary policy implementation more effective in the current environment, particularly as
it relates to a bank's demand for reserves.2
But first, let me start with a brief take on the current economic outlook. There is
much to be encouraged by in the nation's current economic performance even as some
notable risks require careful monitoring.
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The labor market continues to perform remarkably well, providing a key pillar of
support for the rest of the economy. The unemployment rate is at a 50-year low. The labor
force participation rate has been steady for some time now despite continued predictions
for its decline premised on an aging population moving into retirement. Taken together,
low unemployment and steady participation have boosted the employment-to-population
ratio, which has finally surpassed its pre-crisis level. A strong labor market, in turn,
supports a healthy pace of consumption growth and the economy more generally.
There has been some public discussion about what constitutes a tight labor market.
I am in the camp that believes that some additional slack remains in the market, particularly
in the potential for higher labor force participation. I have spoken for some time about my
confidence that a strong labor market will continue to draw in workers-and lead other
workers to delay retirement or otherwise remain in the labor force-and, so far, I remain
optimistic.
Although I feel good about the outlook, a few developments give me pause.
Significantly, investment continues to be weak, declining over the course of 2019.
Increasing the capital stock and investing in new technologies are important for
productivity growth, rising living standards, and the economy's long-run growth rate, so
reversing the recent downward trend is essential for the overall health of the economy.
In part, the fall in investment likely reflects business concerns over the pace of
global growth and risks to the outlook. In particular, 2019 was a bad year for economic
growth among U.S. trading partners, and, as a consequence, our exports suffered.
Recently, I have been encouraged by the progress in U.S. trade negotiations. I am hopeful
that the recently signed phase-one deal with China will boost U.S. exports and lead to
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considerable reduction in the uncertainty that has been weighing on businesses, as will the
continued progress in enacting the trade agreement with Canada and Mexico.
While the recent progress on trade should boost business confidence, the outbreak
of the Wuhan coronavirus introduces a new element of uncertainty. In addition to the
human toll, the virus also threatens significant economic disruption, particularly for China
and its neighbors, as workers and consumers stay home and normal activities are otherwise
disrupted. It is too early to say what the full economic effect of the outbreak will be, and
this situation will require careful monitoring.
In summary, I remain optimistic about the outlook, but I am also highly aware that
some notable risks still threaten growth, both overseas and at home.
A few words on inflation. Both headline and core inflation, as measured by the
price index for personal consumption expenditures, or PCE, came in at 1.6 percent in
December, somewhat below the FOMC's 2 percent objective. This deviation does not
worry me that much, in part because I expect inflation to move back to target over the
medium term, in part as some unusually low readings in early 2019 pass out of the data.
Already, various trimmed price indexes are running much closer to 2 percent.
Monetary Policy Considerations
I view the current stance of monetary policy as appropriate given the economic
outlook and relatively muted inflation pressures. Policy is in a good place to support
continued economic growth, strong labor market conditions, and inflation returning to
target. That said, now is a good time to be thinking about the challenges that monetary
policy is likely to face in the coming years.
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One important development, as I mentioned at the start, is that interest rates at home
and abroad have declined significantly from their pre-recession levels. Policymakers,
economists, and market participants see much of this decline as reflecting a permanent fall
in the equilibrium rate of interest-that is, the level of the federal funds rate that keeps the
economy at full employment with stable inflation in the longer run. For example, in the
most recent Summary of Economic Projections compiling the individual forecasts of
FOMC participants, the median estimate of the longer-run federal funds rate, a value that
incorporates policymakers' assessments of the equilibrium rate, was 2-1/2 percent, down
from 4-1/4 percent in early 2012.3
All else being equal, a fall in the equilibrium rate of interest lessens the scope for
the FOMC to cut rates in response to a significant economic downturn, as the distance to
zero shrinks. In the absence of compensating policy actions, this situation may aggravate
economic downturns. Thankfully, in practice policymakers have several additional tools to
ease financial conditions and support the economy.
One such tool is forward guidance: By credibly conveying to the public that
policymakers will likely pursue a path for the policy rate that is lower than previously
anticipated, policymakers can put downward pressure on longer-term interest rates. In
addition, policymakers can implement policies such as large-scale asset purchases (LSAPs)
that affect the size and composition of the balance sheet: By purchasing longer-term
securities in the open market, the Federal Reserve reduces the quantity of such assets
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available for purchase. The increased scarcity tends to raise the price of these securities
and depress their yields. Balance sheet policies can put further downward pressure on
longer-term yields by reinforcing the credibility of the forward guidance if these policies
are seen as a signal that policymakers intend to keep the policy rate low for an extended
period.4
The FOMC used both forward guidance and balance sheet policies in response to
the financial crisis. Some observers argue that forward guidance and asset purchases fully
offset the shortfall in policy accommodation caused by a lack of space to cut interest rates
further, so that the limits on the Fed's policy rate did not ultimately constrain our policy
response to the financial crisis. Other observers see these policy tools as having had, at
best, a small positive effect on the economy. Somewhere between these two extremes, the
majority view is that forward guidance and balance sheet polices likely made up for some,
though not all, of the shortfall.5
The experience gained with these tools during and after the financial crisis will
likely facilitate their prompt and effective deployment in future episodes when there is no
longer space for further cuts in the policy rate.
In retrospect, many of the potential negative effects associated with forward
guidance and LSAPs did not materialize. In particular, inflation remained contained, and
longer-run inflation expectations did not become unanchored. A large balance sheet did
not prevent the FOMC from raising the policy rate when it deemed such action was
appropriate.
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To gain the full benefit of our toolkit, it will be important to continue to
communicate clearly about our willingness to use all of our tools in future downturns.6
The greater the public confidence that policymakers will use these tools in response to
episodes when the ability to cut the policy rate is constrained, the more real longer-term
interest rates will systematically decline in response to negative economic developments,
providing an automatic stabilizer to the economy. Moreover, public confidence in the
FOMC's ability to react to economic downturns-even when the policy rate is very low-
will support the resilience of longer-term inflation expectations at levels consistent with the
FOMC's objective. Keeping inflation expectations anchored will in turn further support
the FOMC's ability to lower real interest rates if the economy were to weaken
substantially.
Balance Sheet Policies and Reserve Demand
Taking stock, I note that one approach to the constraints on policy imposed by the
current low level of interest rates is to make what were previously unconventional tools-
balance sheet policies and forward guidance-as conventional as possible. Although I
fully support the FOMC's current plan to purchase Treasury bills and increase the size of
the balance sheet in the very short term, over the longer-term, I believe that the viability of
balance sheet policies is enhanced if we can show that we can meaningfully shrink the size
of the balance sheet relative to gross domestic product following a recession-induced
balance sheet expansion. In effect, I believe that balance sheet policies are more credible if
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we can show that there is not a persistent ratcheting-up effect in the size of the Fed's asset
holdings.
Of course, the balance sheet is not going back to pre-crisis levels, when the size was
primarily determined by the Fed's currency liabilities. As the FOMC announced in
January of 2019, the Committee intends to implement monetary policy in an ample-
reserves regime.7 With that approach, control over the level of the federal funds rate and
other short-term interest rates is exercised primarily through the setting of the Federal
Reserve's administered rates and is not, over the longer term, reliant on frequent and large
open market operations. The Committee also reiterated that it would assess the level of
reserves most consistent with efficient and effective monetary policy implementation.
Questions about this level have moved to the forefront following market dislocations and
money market pressure amid a temporary, but pronounced, reduction in the supply of
reserves as a result of an increase in our nonreserve liabilities in September. Indeed, this
episode has been cited by a number of firms and analysts who estimate that the amount of
reserves consistent with an ample framework was higher than they previously had thought.
Following the mid-September volatility, the Committee stated that it would seek to
maintain, over time, a level of bank reserves at or above the level that prevailed in early
September, a level that we believe is sufficient to operate an ample-reserves regime.
Looking ahead, I judge that it is reasonable that we ask ourselves whether it may be
possible to operate with a lower level of reserves and remain consistent with the ample
framework.
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I will spend the remainder of my time exploring possible means to enhance the
efficiency of our monetary policy implementation, including reserve provision, through
adjustments to our existing regulatory and supervisory regime. In particular, I will focus
on liquidity regulation and supervision as well as interactions with monetary policy tools.
And I will suggest a policy-based approach to some of the issues I identify.
Before going into more detail about what I mean, let me emphasize that I will be
touching on some issues that the Federal Reserve is in the process of observing and
evaluating and, in some cases, may be far from reaching any final decisions. As such, my
thoughts on these issues are my own and are likely to evolve, benefiting from further
analysis and monitoring of bank behavior and financial markets over time.
Let me take a step back to highlight some of the key features of the current liquidity
regulation and supervision regime, features that have resulted in significant increases in the
liquidity resilience and risk-management capabilities of our largest institutions. Taken
together, these features-including the Liquidity Coverage Ratio (LCR), Regulation YY's
enhanced prudential standards, and resolution planning-require large firms to demonstrate
that they hold sufficient liquid assets to meet outflows in stressed scenarios and in
resolution.
In short, we expect firms to manage their liquidity risk prudently-to self-insure-
so they can withstand the types of runs we saw during the crisis without relying on
taxpayer support. This outcome has contributed to a more resilient financial system and
leaves taxpayers in a much better place today.
Following the implementation of these requirements, large banks have more than
doubled their buffers of liquid assets. More specifically, our largest banks have
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significantly increased their holdings of assets known as Level 1 high-quality liquid assets
(HQLA). Level 1 HQLA includes central bank reserves, Treasury securities, and Ginnie
Mae securities.
As discussed in the original design for the LCR, all forms of Level 1 HQLA are
treated as substitutes. There is no preference for reserves versus, say, Treasury securities in
the calculation of the ratio.
Despite the regulatory text's equal treatment of Level 1 HQLA, we know that
reserves have special characteristics when it comes to stress. Even though the Treasury
market is the most liquid in the world, in an actual stress event, banks would still need to
take steps to monetize Treasury securities to meet cash outflows.
However, it may be difficult to liquidate a large stock of Treasury securities to meet
large "day one" outflows. For firms with significant capital market activities, wholesale
operations, and institutional clients (such as hedge funds), this scenario is not just
theoretical. In the global financial crisis, several firms experienced outflows exceeding
tens of billions of dollars in a single day.
The LCR does not capture these on-the-ground realities. But supervision does.
Under Regulation YY's enhanced prudential standards, large firms are required to conduct
internal liquidity stress tests (ILSTs). Supervisors expect firms to estimate day-one
outflows and to ensure that their liquidity buffers can cover those outflows without reliance
on the Federal Reserve. For firms with large day-one outflows, reserves can meet this need
most clearly.
Yet it is worth remembering that a principal reason for the Federal Reserve's
creation was to facilitate the movement of reserves when needed from banks with an excess
reserve position to those in need of reserves.8 Indeed, it is the reason we are called the
Federal Reserve. I do not think that is a fact of purely historical interest. Excessive friction
in the movement of cash in the financial system was likely a contributor to the market
dislocations of last September. In that regard, I think it is worth considering whether
financial system efficiency may be improved if reserves and Treasury securities' liquidity
characteristics were regarded as more similar than they are today-that is to say, that
reserves and Treasury securities were more easily substitutable in the context of liquidity
buffers. To be clear, the ideas I will discuss do not involve any decrease in banks' liquidity
buffers. Rather, I want to explore options that would maintain at least the level of
resilience today while also facilitating the use of HQLA beyond reserves to meet the
immediate liquidity needs projected in banks' stress scenarios.
My suggested options are grounded in the principle that the Federal Reserve has an
important role in providing liquidity to depository institutions. Today this role is played by
the discount window, through which Reserve Banks provide fully collateralized loans to
healthy institutions. While the range of eligible collateral for such liquidity provision is
very broad, it may be worthwhile to focus for the moment on the Federal Reserve's
potential to provide liquidity that is collateralized only by Level 1 HQLA. With firms
posting Level 1 assets as collateral, the Fed would be well positioned to provide liquidity to
bridge the monetization characteristics of HQLA securities versus reserves.
Acknowledging this potential role in stress scenarios, the Fed may promote efficient market
functioning while assuming very limited risk. If firms could assume that this traditional
form of liquidity provision from the Fed was available in their stress-planning scenarios,
the liquidity characteristics of Treasury securities could be the same as reserves, and both
assets would be available to meet same-day needs.
There are a variety of ways we could achieve this outcome. One approach would
be to adopt a policy whereby firms are permitted to assume that the discount window can
be used in their liquidity-planning stress scenarios under certain conditions.
The discount window is meant to be used by healthy banks when it is needed.
While there has long been discussion about how the discount window is "broken" because
of stigma about using it, we know it is still an important part of firms' contingency
planning and preparations. Banks currently pledge over $1.6 trillion in collateral to the
discount window, which means that banks have gone to the trouble of working with their
local Reserve Bank to make sure they have access to the window, if needed, and they have
set aside a portion of their balance sheets as collateral to do so.9
We have also already publicly clarified in the 2019 resolution planning guidance
that firms can assume discount window access in their Title 1 plans if they can meet the
terms for borrowing, such as recapitalizing the bank subsidiary.10
We could build on this approach by also allowing firms to rely on the discount
window in their ILSTs as a means of monetizing, for example, Treasury securities in their
scenarios. This approach would acknowledge a role for the discount window in stress
planning, improve the substitutability of reserves and Treasury securities in firms' HQLA
buffers, and maintain the overall level of HQLA that firms need to hold. Such an approach
could improve the efficiency of monetary policy implementation, as firms might show a
greater willingness to reallocate to Treasury securities, reducing reserve demand and
improving market functioning.
An additional advantage of such an approach is that it could further improve the
incentives of firms to be prepared to use the discount window, which we already know is
important for contingency planning. If firms were to include the discount window in their
plans for how they will weather a stress scenario, they would also need to demonstrate to
supervisors that they are prepared to use it to ensure that their plans are credible. Also,
with this approach, we would not need to set up any new programs. In connection with
this, we are closely examining how international counterparts treat the equivalent of
discount window access in their banks' stress-planning scenarios.
Another approach could be to set up a new program or facility: For example, there
has been much discussion among market participants, as well as policymakers, about the
potential benefits of setting up a standing repurchase agreement, or repo, facility for banks
and how such a facility could improve the substitutability of reserves and Treasury
securities for these firms.11 While this option is still of interest, there may be benefits to
working first with the tools we already have at our immediate disposal.
Finally, some firms and industry observers have pointed to the surcharge for global
systemically important banks, and its partial dependence on year-end inputs, as potentially
exacerbating the issues I have discussed today. Preliminary analysis suggests that changing
those inputs to averages may be helpful. If we were to propose that change, it would not
alter the stringency of the surcharge. As such, this option is something that we are actively
considering.
In summary, there are great benefits to safety and soundness and to financial
stability for firms holding sufficient buffers of HQLA to meet potential outflows in stress.
I am not proposing any changes to this basic framework. What I am proposing is that we
can potentially improve the efficiency of monetary policy implementation by improving the
substitutability of reserves and Treasury securities through adjusting our expectations for
firms in stress-planning scenarios. There are a variety of approaches we could take, but I
think the Fed has a role to play.
References
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https://www.federalreserve.gov/newsevents/pressreleases/monetary20190710a.htm.
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https://www.chicagofed.org/~/media/others/events/2019/monetary-policyconference/3-sims-wu-central-banks-toolkit-pdf.pdf.
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Bound on Nominal Interest Rates," NBER Working Paper Series 25123.
Cambridge, Mass.: National Bureau of Economic Research, October.
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Lower Bound," paper presented at "The Changing Policy Landscape," a symposium
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https://www.kansascityfed.org/publicat/sympos/2012/mw.pdf.