To illustrate my point, consider the figures below. The question I considered is how far the Fed is from transitioning from the figure on the left below to the one on the right. Note, that there are two ways to make this move. First, the supply of reserves (red line) can shift back until it hits the slopping part of the reserve demand curve. Second, the demand for reserves (blue line) can shift out until the slopping part of the demand hits the reserve supply schedule. Or, there can be some combination of both developments. In either case, reserves become relatively scarce, unsecured interbank lending revives, and reserves once again will bear an opportunity costs.
On the supply side, there has been a reduction in reserves going on since August 2014. Initially, the decline was largely due to the the growth of the Treasury General Account (TGA) and overnight reverse repos displacing reserves. Since October 2017 it also been the result of the Fed decreasing reinvestment of principal payments on its asset holdings. Collectively, these actions have led to a decline of about $1 trillion dollars in reserves over the past four years. Reserves are now just over $1.7 trillion. This can be seen in the figure below:
On the demand side, there have been new regulations and apparently a general rise in risk aversion that has led to a higher demand for reserves than existed before 2008. The main regulatory development is the liquidity coverage ratio (LCR) which requires banks to hold enough liquid assets to cover 30 days of withdrawals. The LCR treats bank reserves and treasuries as the top “high quality liquid assets” (HQLA) in meeting this requirement.
This reversal in relationship should mean, all else equal, that that banks will be indifferent between holding bank reserves and treasury bills. However, the most recent Senior Financial Officer Survey indicates that even in this “constellation” of interest rates banks still want to hold a lot of reserves relative to the pre-crisis levels. Specifically, the banks indicate they would want to hold $617 billion in reserve balances. Now the survey only covers banks that currently hold two-thirds of bank reserves. Consequently, extrapolating this number out another third puts the total desired reserve balances at $927 billion. This implies a large rightward shift of the reserve demand curve compared to pre-crisis demand for reserves.
Put differently, the Fed could be back in a corridor system as early as 2020 if it were to put its balance sheet reduction on autopilot. Note that balance sheet would be permanently larger–even after accounting for currency or NGDP growth–at a size near $3 trillion.
The big takeaway, for me, is that the Fed may not be that too far away from a corridor system that maintains a moderately-sized balance sheet (owing to the residual demand for bank reserves). For reasons outlined in my previous post, however, I would prefer a return to a corridor system with fewer reserves and the Senior Financial Officer Survey suggests this outcome is possible.
P.S. Bill Nelson of the Bank Policy Institute had some really interesting comments at the event.
