Scarce vs Ample Reserves
June 14, 2022 | Wholesale Funding Update
In order to combat inflation, the Fed has moved from Quantitative Easing (QE) to Quantitative Tightening (QT). In simple terms, under QT, the Fed buys fewer and fewer bonds, reducing the size of its balance sheet, and encouraging long-maturity yields to rise. In recent weeks, there has been a lot of confusion over the impact of QT on bank reserve balances, which I’d like to address here.
Prior to the global financial crisis (GFC), reserves were scarce, and the Fed targeted the fed funds rate by controlling the supply and demand of reserves. Post the GFC, reserves have been abundant (due to the Fed’s large-scale asset purchases under QE), and the Fed now targets the fed funds rate by varying specific interest rates — the overnight reverse repo rate and the interest rate on reserve balances — without targeting the quantity of reserves.
A couple of reports have expressed concern that QT, which shrinks the amount of reserves in the system, will cause reserves to once again become scarce [1,2]. However, the FOMC has explicitly stated that it plans to keep reserves at an abundant level at the end of QT, and not return to the pre-GFC scarce reserves operating regime. The FOMC’s May 4, 2022 statement on policy normalization explains, “Over time, the Committee intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its ample reserves regime” (emphasis added). The Fed goes on to state that it will stop reducing the size of its balance sheet when reserve balances are “somewhat above the level it judges to be consistent with ample reserves.” So, it’s looking like aggregate reserves will be abundant for the foreseeable future.