Federal Reserve tools for managing rates and reserves

Martin, Antoine; McAndrews, James J.; Palida, Ali; Skeie, David R.

Report

Federal Reserve tools for managing rates and reserves

Abstract: The Federal Reserve announced in January 2019 that it would maintain an ample supply of reserves amid its balance sheet reduction. We model the impact of reserves on banks’ liquidity and balance sheet costs. In competitive general equilibrium, the optimal supply of reserves equates bank deposit rates to the interest rate paid on excess reserves (IOER), consistent with ample reserves. Raising the Fed’s overnight reverse repo rate up to IOER would increase liquidity, expediently reduce the overabundance of reserves, and stabilize the volatility of overnight market rates. Empirical analysis supports our model and can explain recent puzzles in money market rates.

Keywords: overnight reverse repurchases; balance sheet costs; Federal Reserve; liquidity; reserves; banks;

JEL Classification: E5; G21;