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By Jean Yung
WASHINGTON (MNI) - Federal Reserve officials are in the midst of a vigorous
debate over the future of the operating framework for controlling short-term
interest rates, but they agree on one thing: balance sheet wind-down still has a
way to run.
The minutes of the November Federal Open Market Committee meeting, released
Thursday, showed officials weighing the pros and cons of keeping the so-called
"floor" system, adopted after the 2008 financial crisis, now that monetary
policy is normalizing.
The current regime requires substantially higher levels of excess reserves
than before the financial crisis, and the Fed is already a year into a program
to slowly shed assets. But, as the minutes revealed, feedback from bank contacts
as well as internal research have given policymakers greater confidence that
reserve levels are still well above a level that would necessitate a return to
the pre-crisis system.
"Participants noted that the level of reserve balances required to remain
in a regime where rate control does not entail active management of the supply
of reserves was quite uncertain," the minutes said, "but they thought that
reserve supply could be reduced substantially below its current level while
remaining in such a regime."
--MAGIC NUMBER $1 TRILLION
In the wake of new banking regulations and other shifts in market dynamics,
officials are seeking to understand banks' demand for reserves under various
Even as money market rates climbed close to the Fed's administered rate,
the interest paid on banks' excess reserves, in recent months, banks told the
Fed they would still be willing to maintain "substantially higher" levels of
balances than before the crisis, the minutes said.
In a survey of 51 banks that together held roughly two-thirds of total
reserve balances in the banking system in August, respondents identified $600
billion, or about half of current holdings, as the lowest level of reserve
balances they would feel comfortable holding, the Fed said.
Extrapolating that to the banks not included in the survey would point to a
minimum reserves level of roughly $1 trillion, matching the figure Fed sources
identified to MNI earlier this month as the internal working estimate for a
normalized balance sheet.
The Fed trims its bond holdings by about $50 billion a month. With excess
reserves currently standing at around $1.6 trillion, another 13 months of
drawdown would whittle reserves down to around $1 trillion.
The FOMC laid out a number of reasons to keep the floor system, hinting
that officials may be close to a decision.
The current framework has shown itself to be effective and workable in the
extreme conditions of a crisis and through several rounds of large-scale asset
purchases to stimulate the economy, the minutes said.
The Fed's uncertainty over banks' demand for reserves also presents a
drawback for a return to the pre-crisis reserve-scarce regime as it would
undermine the Fed's efforts to target a specific interest rate. An
abundant-reserves framework would not rely on the Fed actively draining or
adding reserves on a daily basis, because changes would be too small as a
proportion of the total to significantly affect interest rates.
Banks indicated in the Fed's survey that they might reduce their views of
the lowest levels of reserves they were comfortable holding only modestly from
current levels if money market rates rose above IOER, the minutes said. Half of
respondents said even if short-term rates rose 50 basis points above IOER, they
would not cut their holdings.
That suggests both policymakers and markets are comfortable with a larger
--MNI Washington Bureau; +1 202-371-2121; email: email@example.com
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