A new Brookings Institution paper offers a broad plan to shrink the Federal Reserve's balance sheet, arguing that a large, fixed stock of reserves is not necessary to implement monetary policy effectively, Reuters reported. The paper, by researcher Hughes and reported by Michael S. Derby, says the Fed can reliably operate through a smaller structural stock of reserves backed by elastic lending capacity.
If the Fed puts less liquidity into the system, it should change its standing repo operations tool, which provides fast cash to eligible firms, to have no cap and a higher rate than the interest on reserves rate, while launching a new Term Liquidity Facility to auction off four-month funding against a broad range of collateral. The Discount Window would remain in the mix for emergency lending, and Fed holdings should be moved to Treasury bills and away from longer-dated holdings, the paper says.
It also proposes that the Fed set a target for the Secured Overnight Financing Rate and stop targeting the federal funds rate, echoing how the Bank of England provides liquidity to markets while drawing on past liquidity facilities offered by the Fed. Hughes writes that new facilities must be paired with policy changes to reduce structural reserve demand, in part by changing banking regulation rules and how the Treasury manages its large cash account at the Fed.
Hughes hopes the Fed balance sheet task force will "deliver a concrete blueprint" for contracting Fed holdings rather than just a list of options, Reuters reported, adding that leadership from the Chair is critical given the overlapping mandates and interlocking tools required, while noting Congress could also legislate the change.
Hughes writes that the development of new facilities must be paired with policy changes to reduce structural reserve demand, and this can be done in part by changing the rules around banking regulation as well as how the Treasury manages its large-sized cash account at the Fed. "New liquidity facilities and policies to reduce reserve demand are necessary complements; neither effectively delivers a permanently smaller balance sheet without the other," Hughes wrote, according to Reuters.
The paper lands as the Fed itself weighs the future of its balance sheet through an internal task force. Hughes hopes that group will deliver a concrete blueprint for contracting Fed holdings rather than a mere list of options, arguing that leadership from the Chair is critical given the overlapping mandates and interlocking tools required, while noting Congress could also legislate the change.