Federal Reserve Tools for Managing Rates and Reserves

The amount of reserves held by the U.S. banking system rose from under $50 billion in mid-2008 to over $1.5 trillion by mid-2011. Some economists argue that such a large quantity of bank reserves could lead to overly expansive bank lending as the economy recovers, regardless of the Federal Reserve's interest rate policy. We analyze a general equilibrium model of banking and money markets to study liabilities management for a central bank with a large level of outstanding reserves. We show that the size of bank reserves has no effect on bank lending in a frictionless model of the current banking system, in which interest is paid on reserves and there are no binding reserve requirements. We also examine the potential for balance sheet cost frictions to distort banks.lending decisions. We find that large reserve balances do not lead to excessive bank credit and may instead be contractionary. We extend the model for the presence of liquidity shocks in order to study various Federal Reserve liabilities management tools, including interest on excess reserves (IOER), a Term Deposit Facility (TDF) and reverse repo (RRPs). We find that the TDF increases the wedge in-between IOER and rates of other assets (such as real sector lending) by increasing the liquidity value of outstanding reserves. RRPs, on the other hand, provide a useful substitute for households holding shares in money market funds to alleviate liquidity risk premia between bond and deposit rates, and to suppress the wedge in between IOER and household investment rates. Daily fixed price, full allotment style RRPs, provide a more effective and practical tool for achieving these outcomes than a fixed quantity counterpart. While both the TDF and RRPs absorb reserves, RRPs do so while exerting a smaller upward pressure on the loan rate-IOER wedge.