Additionally, having some excess capacity, also known as headroom, in ON RRP operations over expected usage is important for the facility’s effectiveness in helping to control rates. One might want such headroom – which provides confidence to market participants that an ON RRP cap will not bind – to be somewhat higher on average if take-up in ON RRP operations becomes more volatile. Given the importance of a successful liftoff to the Federal Reserve’s credibility, the FOMC has indicated an intention to set ON RRP capacity at a temporarily elevated level when policy firming commences to support policy implementation. As always, the Federal Reserve will monitor financial markets closely and make adjustments in its execution of monetary policy, as needed, to achieve its mandated objectives. Changes in money markets The operational approach for policy normalization I described earlier refocuses the mechanism for implementing monetary policy back to money markets, after the post-crisis period in which policy has been driven by large-scale asset purchases. However, we will be operating in a complex, dynamic, and still-evolving market environment that looks much different from the money markets in which the Fed last operated actively to achieve its interest rate objectives. Still, these markets are no less important for the transmission of monetary policy or the broader U.S. financial system than they were before. 19  In order to explore how term tools might be used more broadly during normalization, the Desk also conducted a series of one-week term RRP operations in mid-February through early-March 2015.

The Committee expects that it will be appropriate to reduce the capacity of the ON RRP facility fairly soon after it commences policy firming. I’d like to explore some of these elements in more detail. 1  This measure of reserves includes current balances of RRPs conducted under the Desk’s operational exercise and term deposits. In actuality, balances held in these categories shift the composition of the Federal Reserve’s liabilities away from reserves, although they don’t reduce the total size of the balance sheet. Note that the total quantity of reserves in the banking system is largely a byproduct of Federal Reserve activities (such as asset purchases or lending programs) and the private sector’s demand for other Federal Reserve liabilities (such as currency). Individual bank lending transactions can redistribute reserves, but they do not change the total quantity of them. See Todd Keister and James J. McAndrews, “Why Are Banks Holding So Many Excess Reserves?” Federal Reserve Bank of New York Current Issues 15, no. 8, December 2009. http://www.newyorkfed.org/research/current_issues/ci15–8.pdf. 2  The FOMC’s September 2014 Normalization Principles and Plans and March 2015 meeting minutes are available, respectively, at http://federalreserve.gov/newsevents/press/monetary/20140917c.htm and http://federalreserve.gov/monetarypolicy/fomcminutes20150318.htm. 3  The Committee further specified that it expects to cease or commence phasing out reinvestments after it begins increasing the target range for the federal funds rate; the timing will depend on how economic and financial conditions and the economic outlook evolve.