Next Level Unlocked: The Federal Reserve Bank of New York
Introduction
On behalf of the New York Fed, I welcome you to the 2024 U.S. Treasury Market Conference. Thank you to the distinguished speakers and panelists for joining us, and to the event organizers for their hard work. I'm excited to share a valuable and productive conversation.
This conference is a recurring event, but each year's topics are interconnected. Think of it as leveling up in a video game, where we advance our understanding of the Treasury market. This game is multiplayer, and our decade-long interagency collaboration has been remarkable. We must continue this work, and I mean that in a working sense.
Before I continue, a standard disclaimer: The views I express are my own and do not necessarily reflect those of the Federal Open Market Committee (FOMC) or the Federal Reserve System.
Three Levels of Play
My past conference remarks focused on the Treasury market and our collective efforts. Today, I'll provide a retrospective on the past seven years, explaining how these events and lessons have shaped the FOMC's monetary policy implementation and the design of our ample reserves framework. I'll also update you on the Federal Reserve's balance sheet strategy.
Let's return to the video game analogy and start at level one: the 2014 'flash rally' episode of market volatility. This period reminded us that financial markets evolve with technology, regulation, and new players. Safeguards and systems must adapt to ensure market functionality.
Level two introduced the concept of market resiliency. We learned the importance of creating a system that can withstand the unforeseeable and unpredictable. When these events occurred, as in the 2020 'dash-for-cash' scenario, the Treasury market and related markets experienced significant stress, threatening broader financial conditions.
This leads us to level three: a resilient financial system is crucial for monetary policy. As monetary policy influences the economy through financial markets, its effectiveness relies on well-functioning markets, with the Treasury market at the core.
Good news! We've unlocked the next level of my remarks, explaining the FOMC's approach to monetary policy implementation for effective interest rate control and smooth market functioning.
Framing the Frameworks
Monetary policy implementation frameworks are vital for monetary policy conduct.
The Federal Reserve has multiple goals when supplying reserves to the banking system, often involving trade-offs. Firstly, it targets a policy interest rate level and minimizes its variability. Additionally, it aims to support financial stability and market functioning.
The core of any operational framework is the supply of reserves, which can range from 'scarce' to 'ample' to 'abundant'. The 'price' of reserves is the spread between the market interest rate and the rate earned for holding reserves at the central bank.
A central bank has two tools for reserve supply: setting an ex ante aggregate reserve level and offering lending facilities at an interest rate determined by the central bank. If the ex ante supply is low, lending facilities meet additional demand.
These tools can be mutually reinforcing. Lending facilities limit upward interest rate movements on high-demand days, reducing the ex ante reserve supply needed to control short-term rates.
Federal Reserve: Ample Reserves and Tools
The Fed's operational framework has evolved since the global financial crisis, reflecting its experience with large balance sheets. In January 2019, when asset holdings declined, the FOMC adopted an ample reserves strategy.
The FOMC defines this framework as controlling the federal funds rate and other short-term interest rates primarily through administered rates, without requiring active reserve supply management.
One crucial tool for interest rate control is the overnight reverse repo facility (ON RRP), which, alongside the interest paid on reserve balances (IORB), sets a floor for the federal funds rate. Eligible counterparties 'lend' to the Federal Reserve at the FOMC-set rate, currently the target range's bottom.
The ON RRP adjusts automatically to market conditions, rising and falling with supply and demand, making it flexible and effective in supporting interest rate control. When asset holdings push reserves above ample, the ON RRP acts as a safety valve, ensuring smooth monetary policy transmission.
In 2021, the Federal Reserve introduced the Standing Repo Facility (SRF), complementing the ON RRP by providing interest rate control to the upside. The SRF rate is set at the FOMC's target range's top, reducing day-to-day reliance on the facility.
The SRF plays a critical role in capping temporary upward rate pressure and assuring markets of effective interest rate control and smooth market functioning. It ensures adequate liquidity in various circumstances, differing from other lending facilities that provide liquidity to individual banks.
The SRF has been effective as reserves moved from abundant to ample. Over the past two months, SRF usage has increased, especially on days of temporary repo market pressures, as shown in Figure 2.
Federal Reserve: The Way Forward
At the pandemic's onset, the Fed and global central banks quickly restored market functioning, causing reserves to rise above ample in many jurisdictions.
In June 2022, the Fed began reducing its balance sheet to transition to an ample reserve level. The FOMC intended to stop balance sheet runoff when reserves were somewhat above ample and allow further decline as other liabilities grew.
The process has been successful. Securities holdings have shrunk from a peak of $8.5 trillion in 2022 to $6.25 trillion today. In October, the FOMC decided to conclude the reduction of aggregate securities holdings on December 1, based on clear market signs that reserves were somewhat above ample.
Looking forward, the next step is to assess when reserves reach an ample level. Gradual asset purchases will maintain an ample reserve level as other liabilities grow and underlying demand increases. These purchases represent the natural next stage of the FOMC's ample reserves strategy, without changing monetary policy.
Determining ample reserves is an inexact science. I closely monitor market indicators related to the fed funds market, repo market, and payments to assess reserve demand conditions. Recent repo market pressures and growing signs of reserves moving from abundant to ample suggest we will reach ample reserves soon.
Conclusion
We've reached the endgame of my remarks, and we've learned a lot over the past decade. The FOMC's monetary policy implementation framework supports adequate liquidity under various circumstances. The combination of an ample reserve supply and the Standing Repo Facility enables strong interest rate control and flexibility regarding balance sheet changes.
This operational framework has proven highly effective and continues to work as designed.
