Between 2017 and 2019, the Federal Reserve’s balance sheet shrank by $700 billion, and this runoff proceeded smoothly, during the period when reserves were ample. There are however several differences between the current environment and prior experience. Compared with the prior period, the size of the Federal Reserve’s balance sheet is considerably larger, and the pace of runoff will be faster. The composition of liabilities is also different. ON RRP balances of around $2.2 trillion currently comprise about a quarter of the Federal Reserve’s liabilities. In contrast, when the prior period of balance sheet reduction began, ON RRP balances averaged less than $125 billion, accounting for only 3% of liabilities.
This different composition of liabilities will necessitate a more complex set of adjustments in private-sector balance sheets than during the last episode. However, just as use of the ON RRP facility expanded as the balance sheet grew, shifts in money markets that accompany balance sheet runoff, along with incentives provided by administered rates, should result in ON RRP balances declining from currently elevated levels over time.
The relative pace at which reserves and ON RRP balances decline will depend on the actions of a broad range of money market participants. These adjustments are likely to take time to play out given the size of the ON RRP facility. While ON RRP balances may remain elevated in the near term, the Federal Reserve team is already observing modest shifts in money markets that should lead to smaller ON RRP balances over time.
In a recent speech, Patricia Zobel, System Open Market Account manager pro tem, said that as the Federal Reserve’s balance sheet declines, money market interest rates can be expected to rise relative to the ON RRP rate and for market participants to shift investments away from the facility over time, moderating the decline in reserves.
This will necessitate significant adjustments across a wide range of private-sector balance sheets. The pace of these adjustments may occur at different rates across different institutions, depending on their responsiveness to changing conditions. Staff at the Federal Reserve will closely monitor money markets to help assess whether these adjustments are proceeding smoothly.
Ultimately, the Federal Open Market Committee (FOMC) has stated its intention to slow and then stop the decline in the Federal Reserve’s balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves. The level of reserves needed to maintain ample conditions is uncertain and varies over time. Bank balance sheets have grown markedly since the beginning of the pandemic. It is unclear the degree to which banks’ reserve demand has also shifted — in the most recent Senior Financial Officer Survey, around 40% of banks suggested that the lowest level of reserves they would seek to maintain at rates near the IORB rate has increased since 2019, but nearly all of the remainder suggested that it stayed roughly the same.
The FOMC has indicated that money market conditions will be an important gauge of when reserves are approaching the level needed to maintain ample conditions, and will stop balance sheet runoff when reserves are somewhat above that level. The experience of 2019, when the FOMC formally adopted an ample reserves framework to implement monetary policy, provides a useful guide to inform this assessment, and staff will monitor a broad range of money market indicators. In addition, the standing repo facility is now available, along with the discount window, to address shocks that could unexpectedly arise. Ultimately, the FOMC will manage securities holdings as needed to maintain ample conditions over time.