Report

The liquidity effect of the Federal Reserve’s balance sheet reduction on short-term interest rates

Abstract: I examine the impact of the Federal Reserve's balance sheet reduction on short-term interest rates emanating from the declining supply of reserve balances. Using an exogenous shift in the supply of reserves, I estimate that by January 2019, when the Fed will have reduced its portfolio by $500 billion, the overnight repurchase agreement (repo) spread (relative to the lower bound of the federal funds target range) will be 10 basis points higher and the fed funds spread will be 2 basis points higher than in October 2017, all else being equal. I also find that a declining supply of reserve balances reduces recourse to the Fed's overnight reverse repo (RRP) facility, which might initially dampen the tightening effects on short-term rates of the Fed's balance sheet reduction.

Keywords: Federal Reserve balance sheets; liquidity effect; interest rates; monetary policy;

JEL Classification: E42; E43; E52; G21;

Bibliographic Information

Provider: Federal Reserve Bank of Boston

Part of Series: Current Policy Perspectives

Publication Date: 2017-10-01

Number: 18-1