Randal K Quarles: The future of the Federal Reserve's balance
sheet
Speech by Mr Randal K Quarles, Vice Chairman for Supervision of the Board of Governors of the
Federal Reserve System, at the 2019 US Monetary Policy Forum, sponsored by the Initiative on
Global Markets at the University of Chicago Booth School of Business, New York City, 22
February 2019.
* * *
When I was asked to participate on this panel in the middle of last year, the prevailing metaphor
regarding Federal Reserve balance sheet policy was "as boring as watching paint dry." Well,
times have changed, and I commend the conference organizers for their foresight. Today I would
like to discuss some of the recent decisions that the Federal Open Market Committee (FOMC)
has made regarding the balance sheet and lay out a rough framework for some further issues
1
that are on the horizon.
In January, after much discussion, including in previous meetings, the FOMC announced its
2
intent to continue operating in a framework of ample reserves. In this regime, active
management of the reserve supply is not needed. The Federal Reserve controls the level of the
federal funds rate and other short-term interest rates primarily through the use of administered
rates, including the rate paid on reserve balances and the offered rate on overnight reverse
repurchase agreements. This regime is sometimes referred to as a floor system, because the
administered rates place a floor under the rate at which banks and others will lend in the federal
funds market. In adopting this framework, the Committee stated its intention to continue
operating as it has for the past decade.
The announcement was an important step in our normalization process. And we are now set up
to make further decisions on the eventual size and composition of our balance sheet. Before
providing more context on those decisions, let me first provide a little more detail around our
decision to remain in the current framework of ample reserves.
The most important factor in the decision was that the current system has worked very well. It
has supported the achievement of our dual-mandate objectives of maximum employment and
price stability. And it has shown itself to be flexible and well suited to maintaining interest rate
control through various changes in money markets, bank regulation, and the Federal Reserve's
balance sheet. Since the FOMC began lifting interest rates in December 2015, money market
rates have generally moved closely with the federal funds rate, which in turn has followed
changes in administered rates.
Now that the decision on the operating framework has been made, a natural next step is to
contemplate the appropriate size of the Fed's balance sheet and reserves and the process for
getting there. In line with the requirements of operating with ample reserves--and boosted by the
growth in nonreserve liabilities--the Fed will maintain a larger balance sheet and reserve supply
relative to the pre-crisis period, with the goal of remaining on the flat portion of the reserve
demand curve. I would note that reserves have already declined appreciably from their peak,
falling by $1.2 trillion to a current level of around $1.6 trillion. At the same time, we have seen a
substantial increase in our nonreserve liabilities, such as currency in circulation and the Treasury
General Account balance. In our statement on Policy Normalization Principles and Plans, we
outlined an intention to hold no more securities than necessary to implement monetary policy
3
efficiently and effectively. As the balance sheet continues to shrink, we are now in the process
of determining that necessary size.
Ultimately, the size of the balance sheet will be determined by a number of factors, including
demand for nonreserve liabilities, such as currency (which has been rising), and, importantly, the
quantity of reserves necessary to remain reliably on the flat portion of the reserve demand curve.
Survey results suggest that banks have greatly increased their demand for reserves in the
postcrisis period. Responses to the September 2018 Senior Financial Officer Survey report that
banks would be comfortable with a level of reserves in the system in the neighborhood of $800
4
billion, taking into consideration the level of interest rates at the time. In part, this increased
demand reflects a response to regulatory changes introduced after the crisis. These changes
include, importantly, the Liquidity Coverage Ratio (LCR), which has improved banks' liquidity
resilience by requiring firms to hold sufficient high-quality liquid assets to cover potential outflows
during times of stress. Reserves, along with Treasury securities, are favored under the LCR,
and, consequently, firms currently meet a sizable fraction of their LCR requirements by holding
reserves.
Notwithstanding survey results, the level of reserve demand remains quite uncertain. It is
possible that, over time, the preferences of banks will shift, or that demand will prove more price
elastic than banks are currently expecting. As I have discussed previously, bank holdings of
reserves to meet LCR requirements could shift toward Treasury securities, as aggregate
5
reserves decline, without much upward pressure on the federal funds rate. That said, even if
uncertain, it is probably safe to say that reserve demand is much higher than before the crisis.
As we work to calibrate ample reserves, there are some tradeoffs that are worth noting. For
example, we could operate with a level of reserve balances at the lower end of what might be
considered ample. In that case, there would likely be occasions when unexpected declines in the
supply of reserves or increases in the demand for reserves would require an open market
operation to offset temporary upward pressures on the federal funds rate. Alternatively, we could
operate with an average supply of reserves large enough to keep the federal funds rate
determined along the flat portion of the reserve demand curve even with an unexpected shift in
the supply of or demand for reserves. This approach would be operationally convenient but would
also leave the size of the balance sheet and reserves larger than necessary most of the time. In
my view, it might be appropriate for us to operate somewhere in between these two extremes,
with a sizable quantity of reserves large enough to buffer against most shocks to reserve supply.
On those few days when that buffer is likely to be exhausted, we could conduct open market
operations to temporarily boost the supply of reserves.
With so much uncertainty over the level and slope of the reserve demand curve, a degree of
caution is warranted. As outlined in the minutes of the January FOMC meeting, the Committee
has discussed ending the reduction in the Fed's aggregate asset holdings sometime in the latter
6
half of this year, with still-ample reserves in the system. At that point, one option discussed,
without any decision being made at this point, is to hold the level of total assets roughly fixed for a
time. Even as the total size of the balance sheet remains fixed, the composition of the liabilities
would gradually change, in part as demand for currency grows in line with the economy. Over
time, the gradual increase in nonreserve liabilities would displace reserves as the overall balance
sheet remains fixed. This plan would substantially reduce the pace of the decline in reserves,
allowing us to gradually approach our assessment of the appropriate amount of reserves for the
efficient and effective implementation of monetary policy. Of course, in the longer run, once we
reach our preferred level of reserves, the balance sheet would have to resume growth to match a
continued increase in demand for nonreserve liabilities.
I would like to wrap up with a brief discussion of some of the other decision points we will
encounter as we continue the process of normalizing our balance sheet. In particular, what does
the Committee judge to be normal in regard to the type and duration of assets that we will hold?
On composition, in line with our previously announced normalization principles, I favor a return to
a balance sheet with all Treasury securities, allowing our mortgage-backed securities (MBS)
holdings to run to zero. In those principles, we also state that while we do not expect sales of
MBS as part of the normalization process, later we would be open to limited sales to reduce or
eliminate residual holdings of MBS. In regard to duration, moving to shorten the duration of our
holdings could increase the Fed's ability to affect long-term interest rates if the need arose.
However, it might be preferable to have the composition of our Treasury holdings roughly match
the maturity composition of outstanding Treasury securities, minimizing any market distortions
that could arise from our holdings. Over the course of our upcoming meetings, I look forward to
what promises to be an interesting discussion on these issues with my colleagues.
Finally, in assessing our balance sheet policy, it is important to point out that the Fed remains
entirely focused on meeting its statutory dual-mandate objectives of maximum employment and
price stability. The normalization of the balance sheet is not a competing goal. If ever it appears
that our plans for the balance sheet are running counter to the achievement of our dual-mandate
objectives, we would quickly reassess our approach to the balance sheet.
1
These remarks represent my own views, which do not necessarily represent those of the Federal Reserve
Board or the Federal Open Market Committee.
2
For more information, see the Committee's Statement Regarding Monetary Policy Implementation and Balance
Sheet Normalization, which is available on the Board's website at
www.federalreserve.gov/newsevents/pressreleases/monetary20190130c.htm.
3
The Committee's Policy Normalization Principles and Plans were adopted on September 16, 2014, and can be
found on the Board's website at www.federalreserve.gov/monetarypolicy/files/FOMC_policynormalization.pdf.
The FOMC adopted addenda to the Policy Normalization Principles and Plans on March 18, 2015 (PDF), and on
June 13, 2017 (PDF).
4
The survey is available on the Board's website at
www.federalreserve.gov/data/sfos/files/senior-financial-officersurvey-201809.pdf.
5
See Randal K. Quarles (2018), "Liquidity Regulation and the Size of the Fed's Balance Sheet," speech delivered
at "Currencies, Capital, and Central Bank Balances: A Policy Conference," a Hoover Institution Monetary Policy
Conference, Stanford University, Stanford, Calif., May 4.
6
See Board of Governors of the Federal Reserve System (2019), "Minutes of the Federal Open Market
Committee, January 29-30, 2019," press release, February 20.