As prepared for delivery
Date accessed: October 29, 2018
"U.S. Monetary Policy Normalization is Proceeding Smoothly"
Remarks by
Simon M. Potter
Executive Vice President
Federal Reserve Bank of New York
at
Banque de France
Paris, France
October 26, 2018
Thank you for the invitation to participate in today's discussion about
post-financialcrisis monetary policies.1
My remarks today will focus on the implementation of monetary policy normalization.2
The Federal Open Market Committee (FOMC) has carefully developed and articulated a clear
and transparent normalization strategy and is implementing that strategy. This approach has
instilled confidence-a key to maintaining market stability, which has supported the orderly
functioning of the broader set of dollar money market rates that are important to policy
transmission and financial conditions.3
Against this backdrop, the FOMC has increased the federal funds target rate from the 0 to
1⁄4 percent range that had been in effect between December 2008 and December 2015, to 2 to 2 1⁄4
percent at its last meeting. Additionally, since late last year, when the Federal Reserve began a
program to reduce its securities holdings by reinvesting principal maturities only to the extent
that they exceed gradually increasing caps, the FOMC has reduced the size of the portfolio
holdings from nearly $4.3 trillion to about $4.0 trillion.4 Notably, this month, the principal
payments from the agency mortgage-backed securities (MBS) portfolios are below the level of
the redemption caps. As a result, after nearly $2.1 trillion of agency MBS reinvestment
purchases-due in large part to refinancing activity among U.S. homeowners-there will be no
agency MBS reinvestments for the first time since September 2011.
In my remarks, I will first review progress on the FOMC's program to normalize the
stance of monetary policy, which so far has shown that the Federal Reserve's monetary policy
implementation framework continues to provide appropriate control over the federal funds rate
and other short-term rates. I will focus on the balance sheet and discuss the drivers of the
longrun balance sheet size and composition. Next, I will review the relationship between reserve
levels, which fall as the portfolio declines, and short-term interest rates. Then, I will discuss the
technical adjustment to the rate of interest paid on reserves (IOR), which the Federal Reserve
made in June to provide greater comfort that the effective federal funds rate (EFFR) would
remain within the target range set by the FOMC.5 I will discuss how this adjustment had exactly
the intended effect on money market conditions, and how it has reinforced my certainty that the
Federal Reserve is well positioned to maintain the public's high confidence in its ability to
appropriately control overnight interest rates.
1
I would like to thank Linsey Molloy and Kathryn Chen for their assistance in the preparation of these remarks, Darrian
Robinson and Anne Chen for their assistance with data, and colleagues in the Federal Reserve System for insightful
comments and suggestions.
2
These remarks are focused on the mechanics of policy implementation; see Williams, "'Normal' Monetary Policy in Words
and Deeds," September 28, 2018, for a discussion of the evolution of Federal Reserve policy actions and communications
amid the exit from the extraordinary policy accommodation, and his perspective on what "normal" means.
3
Also see Potter, "Confidence in the Implementation of U.S. Monetary Policy Normalization," August 4, 2018, for a
thorough discussion about the implementation of monetary policy normalization.
4
Statement Regarding Reinvestment in Treasury Securities and Agency Mortgage-Backed Securities, September 20, 2017.
5
The effective federal funds rate (EFFR) is calculated as a volume-weighted median of overnight federal funds
transactions reported by banks on the FR 2420 Report of Selected Money Market Rates. The New York Fed publishes the
EFFR for the prior business day, along with volumes and rate percentiles, on its website daily at approximately 9:00 a.m.
Eastern Time. The EFFR is used as a measure of the typical federal funds transaction and is the way the New York Fed's
Open Market Trading Desk (the Desk) measures its success in meeting the directive on interest rate control from the
FOMC.
As always, the views I will express today are mine alone and do not necessarily reflect
those of the New York Fed or the Federal Reserve System.
Let's begin by reviewing where we are in the normalization process. The Federal Reserve
began its efforts to remove policy accommodation with its overnight policy rate at the zero lower
bound and with a large portfolio of long-duration securities. Normalization, therefore, has two
parts: increasing the overnight rate, and reducing securities holdings.
Short-Term Rate Normalization
First, let's discuss overnight rates. The current monetary policy implementation framework
relies on providing the market with two overnight investment opportunities to help steer short-term
interest rates: interest on reserves (IOR), which is the Federal Reserve's main tool to control
interest rates, and the overnight reverse repurchase agreement (ON RRP) facility, a secondary
tool.6 This framework has proven to be extremely effective at controlling federal funds rates. As
shown in Figure 1, it has maintained the EFFR within the FOMC's target range on all but one day.7
Looking at the distribution of traded rates within both the federal funds and eurodollar funding
markets, as shown in Figure 2, it is also clear that the framework has broadly fostered trading at
rates well within the target range. Indeed, the difference between the 25th and 75th percentiles of
the rate distribution has consistently remained very tight over the course of rate normalization.8
Of course, monetary control does not stop at the federal funds market: our framework
must ensure that the stance of monetary policy is passed through into other money markets. It
has also been very successful in this sense. Figure 3 shows a broad selection of secured and
unsecured overnight money market rates; it is clear that increases in the target range for the
federal funds rate have passed through fully and immediately to the other rates, as expected and
intended.
Moreover, I have been very encouraged by the relative stability and high degree of
comovement among short-term money market rates. Figure 4 shows that the dispersion between
various unsecured and secured overnight rates-another metric that could reflect the efficacy of
policy pass-through-has declined and that these rates have largely converged within the upper
portion of the target range since the end of last year.9 This is due, at least in part, to a large
increase in the supply of Treasury bills, which supported the rise in repo rates to levels closer to
unsecured rates. This also suggests that the framework continues to perform well along this
dimension and perhaps is improving in effectiveness as reserve levels decline. Consistent with
the broad availability of higher-yielding alternatives, ON RRP take-up remains muted, falling to
a record low of $10 million in early September.10
Balance Sheet Normalization
Let me turn now to the second part of normalization: the balance sheet.11 The Federal
Reserve's balance sheet grew markedly over the past decade as a result of large-scale asset
purchase programs, which were undertaken to support the economic recovery by easing financial
conditions to a greater extent than could be achieved solely through reducing the federal funds
rate. Starting late last year, the Federal Reserve began a program to reduce its securities holdings
by reinvesting principal maturities only to the extent that they exceed gradually increasing
caps.12 This gradual and predictable approach is intended to reduce the balance sheet's size at a
measured pace while supporting good market functioning and mitigating the risk of sharp or
outsized asset price reactions.
The charts in Figure 5 show the realized and estimated cash flows from the Federal
Reserve's securities portfolio. The length of the darker bars show the actual amounts of Treasury
securities and agency debt and MBS principal that matured or paid down; only the amounts
above the cap were reinvested. Since October 2017, the Federal Reserve's domestic securities
portfolio has decreased by nearly $300 billion to about $4.0 trillion.13
The lighter bars in Figure 5 show the projected cash flows through the end of next year.
Notably, the caps reached their maximal values this month. Going forward, reinvestment of
Treasury securities will nearly exclusively occur in the middle month of each quarter. As had
been expected in the design of the caps, principal repayments from the agency MBS portfolio
have now begun to come in below the level of the maximum cap. Consistent with the Policy
Normalization Principles and Plans, when this occurs in a given month, no reinvestment occurs,
and the portfolio size declines by the amount of principal repayment. In the future, mortgage
principal repayments, which are sensitive to various factors, especially long-term interest rates,
could conceivably rise above the level of the cap, particularly if interest rates were to decline. If
this were to occur, those amounts above the cap would be reinvested. It is this cap mechanism
that keeps the decline in the balance sheet at a gradual and predictable pace. The New York
Fed's Open Market Trading Desk (the Desk) will conduct operational readiness exercises during
periods of no reinvestment to ensure it remains prepared to reinvest if needed.14
The FOMC's approach to balance sheet normalization-and its transparency and clear
communication about the normalization principles and plans prior to its implementation-was
designed to mitigate the risk of sharp or outsized asset price reactions to the decline in the
portfolio's size over time. Desk surveys corroborate market commentary describing a relatively
limited impact from the reduction in holdings on Treasury yields and MBS spreads thus far. As
shown in Figure 6, comparing a matched sample of survey respondents in our July 2017 surveys
to the September 2018 surveys, the expected impact on 10-year Treasury yields and 30-year
MBS option-adjusted spreads (OAS) during the two-year period following implementation of the
change to the reinvestment policy has declined, likely in part reflecting expectations for the
balance sheet to normalize at a larger size.15 Looking forward, the median respondent currently
anticipates the cumulative impact over the next two years to be 17 basis points for the 10-year
Treasury yield, and 12 basis points for the 30-year MBS OAS.
This gradual expected increase contrasts with the experience of the so-called "taper
tantrum" in 2013, which showed that markets can have outsized and sharp reactions to changes
in balance sheet policy even before they happen. The expected impact of balance sheet
reductions on Treasury yields and agency MBS OAS reflects the FOMC's gradual and
predictable approach to balance sheet normalization, but could also reflect additional factors.
Some argue that robust credit extension by the private sector given the strong economic
environment helps to offset the yield impact from a declining balance sheet. Furthermore, there
are likely some spillover effects across fixed-income markets globally from asset purchase
programs abroad that could affect U.S. term premia.
The Balance Sheet in the Long Run
For many years, the FOMC has indicated its intention that the Federal Reserve will, in
the longer run, hold no more securities than necessary to implement monetary policy efficiently
and effectively, and that it will hold primarily Treasury securities.16 Also, in the June 2017
addendum to the Policy Normalization Principles and Plans, the FOMC noted that reducing the
Fed's securities holdings will result in a declining supply of reserve balances, and that it
anticipates reducing the quantity of reserve balances to a level "appreciably below that seen in
recent years but larger than before the financial crisis."
While the FOMC has articulated how the balance sheet will be reduced, there remains
uncertainty about the long-run size and composition of the Federal Reserve's balance sheet.
Importantly, the size and composition will depend on growth in the various non-reserve
liabilities, demand for reserve balances, and the future monetary policy implementation
framework. The FOMC has not made any decisions about the long-run monetary policy
implementation framework; however, the minutes from the July/August FOMC meeting suggest
that the Committee will likely resume a discussion of operating frameworks in the near future.17
It is also not known how non-reserve and reserve liabilities will evolve going forward; however,
our regular surveys give us a sense of how some market participants are viewing many of these
components, which we show in Figure 7. In particular, the surveys ask respondents about their
expectations for the size and composition of the Federal Reserve's balance sheet, on average, in
2025, under the assumption of no return to the zero lower bound. The responses serve as a good
proxy for expectations about the long-run size of the balance sheet. The median expectations are
for the balance sheet to be $3.6 trillion on average in 2025 and for reserve balances to be $750
billion, or about $1 trillion below their current level.
On the asset side of the balance sheet, the normalized size of the securities portfolio is
one consistent with the longer-run trends in currency and other liabilities. However, even after
the Fed normalizes the size of its balance sheet, the composition of its securities portfolio will
not yet be "normal," as it will not consist primarily of Treasury securities. As you can see from
Figure 8, market participants expect that the domestic securities portfolio could contain roughly
$700 billion in agency MBS on average in 2025.
The Dynamics Between Reserve Levels and Short-Term Rates
As the portfolio shrinks and the level of reserve balances declines, how will we know if
we are transitioning from an environment characterized by abundant reserves to one
characterized by scarce reserves?18 To address this question and understand how the level of
reserves is related to short-term interest rates, we need to review some fundamentals. In the
academic literature on monetary policy implementation, models for the behavior of the overnight
interbank rate generally boil down to its relationship with the stock of bank reserves.19 These
models generally find that as reserve balances decline, the overnight interest rate goes up, but not
uniformly. At high levels of reserves, the responsiveness of rates to changes in reserve levels is
fairly low, and the demand curve is said to be "flat." As excess reserve levels decline, the
responsiveness of rates increases. At low levels of excess reserves, the overnight rate responds
sharply to small adjustments in the level of reserves, and the demand curve is considered
"steep."20
Despite some of the recent upward moves in overnight rates, I don't believe we've
reached the "steep" portion of the demand curve, where aggregate reserves are scarce. Let's run
through some places where evidence of aggregate reserve scarcity might be found. To begin
with, if we were closing in on the "steep" part, I might expect to see substantial above-IOR
lending in the unsecured overnight markets, as at least some banks each day found themselves
short of reserves and had to borrow them from other banks. In fact, the current amount of such
above-IOR lending remains low as a share of the overnight bank funding market, as shown in
Figure 9.21 I might also expect to see shifts in bank payments behavior-for example, more
daylight overdrafts or more effort by banks to "optimize" their payment flows-but I have not
seen this either. Most fundamentally, I might have observed a day-to-day relationship between
shifts in the stock of reserves and overnight interest rates. Figure 10 shows a scatterplot of daily
changes in reserve balances against daily changes in the spread between the IOR rate and the
effective federal funds rate; there is no visible relationship.
Recent experience supports my belief that we are not at the "steep" portion of the demand
curve and aggregate reserve scarcity. On one day in mid-September, there was a large drop in
reserves-of nearly $75 billion-as the Treasury increased its cash holdings at the Federal
Reserve as a result of third-quarter tax receipts, as shown by the red point in Figure 10. As a
result, reserve balances fell to one of their lowest levels in a number of years apart from
quarterends and were close to some private-sector estimates of where reserve scarcity might appear.
Based on a wide range of indicators, and as suggested by the chart, there was no evidence of
reserve scarcity on an aggregate basis; indeed, based on the metric shown, rates were little
changed on this day.
It seems highly likely that we are still on the "flat" part of the curve, where rates move
little in response to shifts in reserves. However, it is still possible that the decline in reserves
might be putting some upward pressure on rates. Even in the "flat" part, the slope of the demand
curve, while small, might be nonzero. This could be true if, for example, the balance sheet costs
of the marginal borrower in overnight money markets were upward-sloping with respect to that
bank's balance sheet size. I see this as a reasonable possibility, and therefore I think it might be
possible that the decline in reserve balances has pushed up overnight rates a bit over time.22
Figure 11 provides some evidence of this dynamic; as the level of reserve balances has declined,
the spread between the rate of interest paid on reserves and the volume-weighted average federal
funds rate has narrowed. In addition, Figure 9 shows that as average rates in the unsecured
markets have increased, trades at lower rates have declined, the whole rate distribution has
shifted up toward the IOR rate, and the share of trading above the IOR rate has slightly
increased. Figure 9 also reveals that the upward pressure in the federal funds market relative to
that in eurodollars is more pronounced. This likely reflects unique dynamics in the federal funds
market, rather than an aggregate shortage of reserves. These dynamics include banks taking into
account the regulatory impact with respect to the liquidity coverage ratio (LCR) benefit when
borrowing from Federal Home Loan Banks (FHLBs) in the federal funds market.23 There is also
borrowing by smaller domestic banks at relatively higher federal funds rates to fund loan
portfolios; these banks generally have limited access to the eurodollar market or other short-term
funding sources.24
Flexibility When Needed: The Technical Adjustment
When overnight rates-including rates on federal funds transactions-edge higher, what
tools does the Federal Reserve have to ensure that they generally remain within the target range
when reserves are abundant? The federal funds target range is an important feature of the
FOMC's public communications, and maintaining control of the federal funds rate and other
money market rates is therefore taken quite seriously. Public confidence in our ability to
maintain rates within the target range is important for ensuring that expectations for the FOMC's
future policy stance are properly incorporated into the term structure of interest rates, and
thereby appropriately affect financial conditions and the broader economy. At the March 2015
joint FOMC Board meeting, it was decided that in a situation of abundant reserves, the Federal
Reserve intends to "adjust the IOER rate and the parameters of the ON RRP facility, and use
other tools such as term operations, as necessary for appropriate monetary control, based on
policymakers' assessments of the efficacy and costs of their tools."25
Earlier this year, rates paid on the bulk of federal funds trading had ticked up, although
they remained within the FOMC's target range. The uptick in the federal funds rates raised a
question as to whether the effective federal funds rate might print above the FOMC's target
range, absent a change in our operational settings.26 To address the rise in the overnight rate
within the range, a technical adjustment to the IOR rate was made at the June FOMC meeting:
the IOR rate was raised by 20 basis points while the FOMC raised the target range by 25 basis
points. Following that change, all rates paid on federal funds borrowings, as well as in other
money markets, rose by about 20 basis points. This made it less likely that the EFFR would be
above the target range. At the September FOMC meeting, the IOR rate and target range were
each increased by 25 basis points, maintaining the five-basis-point spread between the IOR rate
and the top of the target range, as shown earlier in Figure 4.
Since the June technical adjustment, rates on federal funds transactions have continued to
edge higher in the range, and most recently the EFFR has risen to the IOR rate, or five basis
points below the top of the target range.27 It is possible that the EFFR could fluctuate around the
IOR rate or exceed the IOR rate. However, I don't believe that this upward pressure on the EFFR
signals that we've reached balance sheet normalization or that we are at the "steep" portion of
the reserve demand curve, where reserves are scarce. This is supported by the lack of evidence
across a range of indicators signaling aggregate reserve scarcity. Let me be clear: Observing the
EFFR and other rates above the IOR rate is not a sufficient condition for reserve scarcity.28 In the
last few days, even amid upward pressure in overnight funding rates, we still have not seen the
range of signs I described earlier that would indicate reserve scarcity, such as significant
25
See Minutes of the Federal Open Market Committee, March 17 - 18, 2015. Recall that before liftoff, the main concern
was that rates would fall below the bottom of the target range. Thus, policymakers thought term draining operations might
be helpful.
26
Analysis of the data and extensive market intelligence suggested that the slight increase in money market rates within
the target range during the spring months was primarily due to an increase in the supply of Treasury securities and an
associated rise in Treasury bill yields and repo rates. In particular, in the first few months of the year, U.S. Treasury bill
supply increased by over $300 billion, which contributed to a rise in dealer inventories likely financed in the repo market.
The resulting increase in bill rates and associated short-term repo rates created an attractive alternative investment
opportunity for federal funds lenders, notably the FHLBs, which make up about 95 percent of current overnight lending in
the federal funds market. As federal funds borrowers competed for a reduced pool of funds, rates rose. In addition, the
gradual decline in reserve balances due to balance sheet normalization, together with changing dynamics within money
markets-in part due to the regulatory environment, which may have recently prompted some banks to pay up for federal
funds to improve their LCRs-may have helped push rates up a bit over time. For a thorough discussion of this dynamic,
see Potter, "Confidence in the Implementation of U.S. Monetary Policy Normalization," August 4, 2018.
27
While the further move up in the EFFR relative to the IOR rate is not surprising, the pace has been quicker than many
market participants expected. For example, in our July/August 2018 Desk surveys, only 33 percent of respondents who
provided expectations for this spread expected it to narrow to two basis points or less by year end. On the other hand, the
dynamics of the decrease in the spread since June seem very similar to earlier periods, as can be seen in Figure 9. In
particular, as noted above, rates on eurodollar transactions have lagged.
28
The distribution of reserves throughout the banking system has important implications for rates and volumes in the
federal funds market. Federal funds and other market rates above the IOR rate could reflect frictions related to the
distribution of reserves across the banking system; this dynamic may occur at levels of reserves not consistent with
aggregate reserve scarcity. For further discussion, see Afonso, Armenter, and Lester, "Size Is Not All: Distribution of
Bank Reserves and Fed Funds Dynamics," Federal Reserve Bank of New York Liberty Street Economics (blog), July 11,
2018.
interbank volumes trading at rates above the IOR rate, increased overdraft activity, shifts in bank
payments behavior, or a day-to-day relationship between shifts in the stock of reserves and
overnight interest rates. As discussed earlier, the upward pressure in EFFR likely reflects the
premium on borrowing from FHLBs in fed funds relative to other funding sources. In addition, it
also likely reflects bargaining dynamics among banks with limited access to alternative
shortterm funding sources. Let me also note that the question of the appropriate longer-run balance
sheet size, the point at which the Federal Reserve holds no more securities than necessary to
implement monetary policy efficiently and effectively, is a related, but distinct policy judgement
upon which the FOMC has made no decision as yet.
We will be monitoring that broad range of indicators to search for evidence that we're
approaching the "steep" slope-and I have confidence that our data and analytics will help us to
assess this effectively.29 We have also conducted a new Federal Reserve survey specifically
designed to support our efforts to obtain a high-quality estimate of where aggregate reserve
scarcity might occur, and the preliminary survey results strongly support my view that reserve
scarcity is some way off.30 Finally, I am confident that the Federal Reserve has the effective
tools and is prepared to take measures as appropriate to ensure that short-term rates remain
wellcontrolled and efficiently transmit the stance of policy into broader financial markets. For
example, another technical adjustment to the IOR rate, as discussed in the May FOMC meeting
minutes, could be used to foster trading in the federal funds market at rates well within the
FOMC's target range.
Concluding Remarks
I remain highly confident that the FOMC's framework for the normalization of the stance
of monetary policy-both in the overnight market and the balance sheet-will continue to
proceed smoothly, without unnecessary surprise, disruption, or volatility in financial markets.
The monetary policy implementation framework continues to provide the FOMC with excellent
control over overnight money market rates, and has proven to be flexible, including through the
technical adjustment, in the face of new developments.
Thank you for your attention. I look forward to the panel discussion.
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