The below transcript has been republished from Macro Musings, a podcast hosted by David Beckworth of the Mercatus Center. Listen to the podcast episode.
David Beckworth: Roberto, welcome back to the show.
Roberto Perli: David, thank you. Thank you very much. It's a great pleasure to be here, to be back, actually, after, what, three years, I think?
Beckworth: Yes. Last time you joined us, it was October 2020, a very different conversation than we'll have today. Back then, FAIT had just been introduced. We were talking about it. I think we talked about how it was similar to temporary price-level targeting and some of the issues surrounding it. I think that I, back then, was promoting nominal GDP targeting, but that's not our conversation today. Today, we're going to talk about Fed's balance sheet, its runoff plans, and the big announcement that came out at the last FOMC meeting, and your role, your role in all of this as the SOMA manager. So, a lot has changed since we've talked last. You were in the private sector. You're now at the New York Fed, and I'm curious to learn about your role. But for those listeners who weren't there for the first show, maybe go back and tell us, how did you get into macroeconomics and this journey to where you are today?
Perli: Sure. I'll do that. But before I start, let me do this. Let me offer the usual disclaimer that the views that I express today are my own and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System. I say that not because the Federal Reserve will have any official views on what drove me to economics in the first place, but I think you will probably want to talk about something later on, on which the Fed will have some views. So, I think the disclaimer here is important, and so I said it before I forget it.
Perli: Anyway, so what drove me to economics? Look, I grew up in Italy and went to college there, the University of Venice. In Italy, you have to pick your major from the very first day, not like here, where you can take a couple of years to decide. I chose economics because, to be perfectly honest, I didn't know yet what I wanted to do exactly. I thought that an economics degree offered a broad range of future possibilities. That was it.
Perli: Then, the more I learned about economics, about the subject, I started developing, I think, a genuine interest about macroeconomics and how macroeconomic policies can affect the lives of so many people and so I also developed, I think, an interest in research. And with the help of my advisor at the time, I managed to get admitted to a few graduate schools in the US and the UK, and I picked NYU because I wanted to work with a specific professor.
Perli: I was pretty sure that I wanted to become a professor of economics at that time, because I really liked the subject, and so I did. Then, I became a professor at the University of Pennsylvania. It was my first official job. But then, I realized, like it often happens, what you think you really like to begin with, you really don't like it after a while [when] you're doing it. And so, I was fortunate enough to be hired into the Board of Governors a couple of years after I joined Penn.
Perli: Vincent Reinhart hired me into a group that, actually, was a pretty interesting group over there, because it included Brian Sack, who was another future SOMA manager, Bill English and Jim Clouse, who went on, both of them, to become secretaries of the FOMC, and of course, Don Kim and Jonathan Wright of the famous Kim and Wright term premium models, Stefania D'Amico and Min Wei of the also famed D'Amico, Kim, and Wei model, which, I think, if I remember, you used to look at in the past. Anyway, it was a very good group, and there is where I really learned how monetary policy is made, and it was an incredible experience. I left for the private sector, but then this opportunity came up in the last year, and it was, I think, too good to pass, so here I am.
Beckworth: I will mention that two of those individuals that you brought up, Brian Sack and Bill English, are previous guests of the show as well, so they've been on here. And you're now the head of the SOMA. You lead it. Tell us about that role. What do you do there? What is it like to manage the staff that you do? What is a typical day in the life of a SOMA manager?
Breaking Down the Role of SOMA Manager
Perli: As you know, the New York Fed is one of the 12 regional Federal Reserve Banks spread across the United States, and along with the Board of Governors, we form what's called the Federal Reserve System. So, as a SOMA manager, one of the things that I'm in charge of is managing the SOMA for the System Open Market Accounts. The system is the keyword, so it means that we manage the portfolio for the whole Federal Reserve System, not just the New York Fed. The New York Fed is what is called the selected bank, because the FOMC selects, actually, the New York Fed every year to be the bank that executes transactions for the System Open Market Account. In fact, the FOMC has selected the New York Fed every year since, I believe, 1935 to do this particular job.
Perli: And so, the New York Fed has the Markets Group, which is one of the largest groups within the New York Fed, and it performs a lot of functions, including providing financial services for other central banks and official institutions that have accounts with us, providing capital market services for the US Treasury, housing the discount window function for the New York District, and several other things. But then, of course, within the Markets Group, there is the so-called Desk, the trading Desk, which implements monetary policy via open market operations and monitors and analyzes domestic and also global financial markets.
Perli: And so, in my current role [as] the SOMA manager, I'm responsible for exactly that; implementing monetary policy at the direction of the FOMC, as well as monitoring, analyzing, and communicating global financial market developments to the Committee. So, I participate in every FOMC meeting, and during the meeting, I brief the FOMC on financial market operational developments and answer, or try to answer, their questions. The briefing that I do draws on all of the work that the staff here in the Markets Group does, which includes market portfolio analysis, as I said, but, also, I want to mention our outreach effort, the collection of market intelligence and information, as well as the survey of primary dealers and survey of market participants that we administer regularly every FOMC cycle. So, overall, it's a very fun job, I think, and, definitely, I'm very happy to be in this seat.
Beckworth: Just to be clear, when you say that you oversee the execution of monetary policy, that's every part of it? So, that would also include all of the facilities the Fed has set up, like the standing repo facility, currency swap lines. Would that be a part of your responsibility as well?
Perli: Yes. So, we operate, every day, the overnight repo repurchase agreement facilities, ON RRP. Every day, we do the securities lending operations. Right now, we don't do, of course, outright purchases anymore, but the Desk used to do them when QE was going on. So, all of that is, or was done, here at the Desk. Of course, we also operate the swap lines with five large foreign central banks. Of course, those were much more popular at times of stress in global financial markets. Right now, the utilization of those facilities is minimal, but the fact that, right now, the utilization is minimal doesn't mean that they're not important. Of course, they're very important, should something happen that disrupts financial markets. So, bottom line, we do all sorts of operations here on the Desk.
Beckworth: Okay, so, last time we were talking— again, it was in late 2020, the Fed was expanding its balance sheet. It grew rapidly, grew to [all-time] new highs, and since then, it's been reducing it. So, maybe you could just recap for us what has happened over the past few years to the Fed's balance sheet, just to bring us up to speed so we can look at your speech.
Recapping the Fed’s Balance Sheet Activities
Perli: Sure. As you know, since June 2022, the Fed has been shrinking the portfolio. So, our portfolio has been reduced, over that time, by more than, actually, $1.5 trillion, about $1.25 trillion, roughly, in Treasuries and about a third of a trillion in MBS. So, it's a big amount over less than a couple of years. Now, the process has gone, obviously, very smoothly in the sense that control over short-term interest rates has continued to be very strong. In fact, the federal funds rate has been extremely stable within the target range almost every day at exactly eight basis points above the bottom of the target range, so, extremely, extremely stable within the range.
Perli: There has also been no utilization of the standing repo facility outside of, of course, test transactions, which basically means that there has been no need, as of now, at least, to rely on this facility to keep the funds rate within the target range. The stability of the funds rate has also propagated to other money market rates. Repo markets, for example, have also been very stable, of course, not as stable as the federal funds rate, but we have seen occasional signs of funding pressures confined mostly to quarter ends, month ends, maybe days where there were large settlements of Treasury auctions, and maybe tax days, but they are occasional, very occasional pressures.
Perli: I think it's true that these modest pressures are something that's relatively new, with respect to the post-pandemic period, because they really started emerging probably in the fall of last year. But before the pandemic, these type of pressures were fairly common. So, the fact that they emerged, I wouldn't attribute it to QT. I would just attribute it to a normalization of the environment [compared] to what it used to be. Anyway, in any case, I think things have gone fairly well so far.
Beckworth: There's a lot of questions I could ask about this, but let me begin with this one. How do you think about QT, which is popularly called the reduction of the Fed's balance sheet? Is it the reverse of QE? Is it different? Does it have less of a bang? How do you think about QT, and how should we think about it?
How to Think About Quantitative Tightening
Perli: Well, QT is the reduction of the portfolio, and, of course, QE had an effect on financial markets. There is no reason to think, I believe, that QT is not going to have an effect as well. In fact, I would look at the time period between, say, September 2021 and June of 2022, when QT started. So, between September of '21 and June 2022, there was a continuous crescendo of Federal Reserve communications about the portfolio.
Perli: So, we went from no tapering to maybe tapering of QE, definitely tapering of QE, no QT, maybe QT, fast ideas, so faster QT, then even faster QT, and then the final announcement. So, again, continuous crescendo of communication in that direction. And if you look at what term premiums did over that period of time, they increased. Why did they increase? Well, because the market adjusted its expectations about the ultimate size of the balance sheet; very large and a little bit smaller, and smaller still, and smaller still, and continued reduction of the expectation of the ultimate size of the Fed's balance sheet between September and June.
Perli: And so, that's exactly how I would have expected things to work. The market adjusted expectations about the ultimate size, the total stock, of QT, if you want, over time. And progressively, as this adjustment took place, term premiums [and] interest rates went up. So, yes, I do think that QT had an effect. Of course, since then, a lot of other things happened that influenced the total supply of securities. And so, the term premiums go up and down, but over that period of time that I mentioned, we can isolate, pretty well, the impact of just the balance sheet over everything else, and I think that the effect on interest rates was pretty noticeable.
Beckworth: So, two big categories for the Federal Reserve's liabilities on the balance sheet are the reserves and the overnight reverse repo facility, which you mentioned. I think most people who listen to the show know both of those well. For those who may not, maybe talk a little bit about the overnight reverse repo facility. What is its goal, its use, its history, and how do you find it useful?
Breaking Down the Overnight Reverse Repo Facility
Perli: The ON RRP is a facility that was designed to provide a strong floor on short-term interest rates. So, the idea is that by offering an alternative risk-free overnight investment option to a number of counterparties that normally do not have access to remunerated balances at the Fed— I'm talking about mostly money market funds, but also GSEs— By doing that, the ON RRP essentially disincentivizes lending in the market at a lower rate, and it has been extremely effective in doing so. So, the funds rate has never been anywhere near the bottom or the very bottom of the target range, so, a very, very solid floor.
Perli: What we learned over time, during all of these last several years, is that the ON RRP has been very responsive to market rates. So, the ON RRP has declined about $1.7 trillion between, say, June of last year, when the debt ceiling was postponed, and today, so, a $1.7 trillion decline. And that decline has come, basically, because over this period of time, the supply of Treasury bills has increased as the Treasury rebuilt the Treasury General Account after the debt ceiling was suspended. So, we had to issue a lot of Treasury bills. A lot of Treasury bill issuance increased the yield of Treasury bills over other market instruments, including over the ON RRP. And so, money funds rationally moved away, progressively, from the ON RRP towards this other instrument, Treasury bills, that provided a higher yield. So, in that sense, the ON RRP has functioned exactly as it was intended.
Perli: It has also, I think, been very useful in absorbing virtually the entirety of the balance sheet runoff. So, if you look at where the ON RRP was when the balance sheet runoff started in June 2022 and where it is today, it declined about $1.7 trillion, about the same amount that the balance sheet declined, which is important, because this also means that over that same period of time, reserves remained roughly constant; up and down a little bit, but on a trend basis, they remained constant. And so, this means that, again, as I said, the entirety of the balance sheet runoff was absorbed, not by reserves, but by the ON RRP. And so, reserves have remained abundant within the banking system. So, overall, I think that the ON RRP has worked, really, as intended, and I should say, it has also been very useful in absorbing temporary shocks. For example, think about the spring of last year, when the banking system was under some stress. Money was flowing out of bank deposits and initially went to larger banks and then eventually ended up into money funds and, therefore, into the ON RRP.
Perli: But, at times of need, the banks needed to borrow liquidity, and they borrowed mostly from the home loan banks. The home loan banks issued notes to meet this demand for bank funding. Because they issued these notes at the yield that was higher than the ON RRP, money funds exited the ON RRP and bought these notes, these home loan bank notes. That means, essentially, that money funds channeled money away from the ON RRP and back into the banking system where it was most needed. Then, of course, the situation normalized, and these dynamics ended, but at the time, when it was needed, the ON RRP, again, functioned as intended. It acted as a buffer against the shocks that were hitting the financial system at the time. So, overall, I think I'm very happy with the way the ON RRP has behaved here.
Beckworth: Were you surprised by any of this? I ask because, ex-post, it seems obvious. Okay, Treasury issues a bunch of T-bills, it pulls funds away from the overnight RRP, but at the very beginning, it wasn't very clear to me whether reserves would drain first or overnight RRP would drain first. In hindsight, it seems pretty clear what happened, but going into it, was there an expectation that one or the other would do most of the work?
Perli: Let me say [that] I'm not surprised that the ON RRP worked the way it did because, look, I think it's rational. So, interest rates on alternative instruments like Treasury bills, repos, home loan bank notes, at times, became higher than the ON RRP. So, why should money market funds leave money at the ON RRP and leave some performance on the table? So, no, I'm not surprised that the ON RRP worked as well as it did.
Beckworth: What is the ultimate objective? Is it to run it down to zero?
Perli: I don't know that we can say that there is an objective here. So, the ON RRP is a facility that is there every day. We run this operation every day. It's up to money market funds or the counterparties in this facility— money market funds for the most part, but also GSEs, as I said, and others— yes, it's up to them to decide how much they want to take up every day. I would say, though, that we do expect that the ON RRP will probably continue to do what it has been doing since June of last year, which [it] has been going down. It was going down very fast until a month or so, a month or two ago, but then it slowed down a little bit. Why has it slowed down? Because, among other things, Treasury bill issuance became negative, especially after mid-April with the tax inflows.
Perli: But, eventually, bill issuance will become positive again on a net basis, and so, there is no reason to believe that the ON RRP will level off at the level where it is today, which is, again, in the $400 billion to $500 billion range. I, personally, do continue to expect it to go down. Will it go exactly to zero or will it level off at some positive number? That's very hard to tell. There are some reasons why some money funds may want to leave some funds in the ON RRP, regardless of rates, just for operational convenience, essentially.
Perli: But from a point of view of reserve management, the implications are the same. Whether the ON RRP goes to zero or whether it levels off at some positive level, whatever that level will be, once that happens, reserves will start going down one for one with the shrinking of the portfolio, everything else equal. And so, this is one of the reasons, I think, why the FOMC decided to slow down— that the slowing down the pace or shrinking of the portfolio was a good idea, was a prudent idea.
Beckworth: Let's talk about that. Before I do, just to acknowledge your point, what you're saying is that the overnight RRP is kind of an endogenous facility. It responds to changes. So, whatever the Treasury does, [and] Congress does, could have a bearing on the future balance that ends up being there. That's a great point. Let's talk about the decision from the last meeting to slow down the runoff. Maybe tell us what it is and what it might mean for the future of QT.
Slowing Down the Runoff and the Future of QT
Perli: Yes, so, as we discussed, the FOMC has been shrinking the portfolio since September 2022. It has been doing so by imposing some caps as to how much Treasuries and MBS securities can be reduced every month. So, those caps have been $60 billion per month for Treasuries and $35 billion per month for MBS. Of course, the MBS cap has not been binding, because interest rates have increased in recent years, and so prepayments have been very low. But, on average, the MBS portion of the portfolio has declined about $16 billion per month. So, in total, $60 billion of Treasuries plus about $16 billion on average, per month, for MBS equals about a $76 billion per month base of shrinking of the portfolio since September of 2022, which is when the caps reached the amounts that I just discussed.
Perli: The Committee decided, at the May 1st meeting, that starting in June, the Committee decided to lower the cap for Treasury securities from $60 billion per month to $25 billion per month and to leave the MBS cap unchanged at $35 billion per month. Also, the Committee decided that any MBS prepayments in excess of the cap should be invested in Treasury securities in a way that roughly matches the distribution of Treasury securities outstanding. So, I think that the chance that there will be MBS principal payments in excess of the cap, I think, is very low, given the current interest rate configuration, but the decision to leave the MBS cap unchanged, even if it is unlikely to be binding, is consistent with the FOMC's intention to hold, primarily, Treasury securities in the long run.
Perli: So, if you do the math, you say that you take the $25 billion in Treasuries, the new cap, which will be, again, binding every month, and you add to it a $16 billion average MBS unchanged from the past, and so that equals about a $40-$41 billion per month reduction in the portfolio, which is just a shade more than half of the roughly $76 billion average per month that we have seen so far. I think it's 54% or so. So, why did the FOMC make this announcement? Well, because they thought that slowing the pace of runoff will help ensure the smooth transition from a regime of abundant reserves to a regime of ample reserves, or closer to ample anyway, and that it would reduce the possibility that money markets would experience stress, like they did a few years ago. Also, they thought it would facilitate the ongoing decline in our securities holdings that are consistent with reaching the appropriate level of ample reserves.
Perli: So, it's an important, maybe subtle point, but an important point nonetheless, [that] the announcement did not represent a shift in the monetary policy stance. Instead, it was just the implementation of a policy decision, slowing the pace of runoff at the appropriate time, that was made in accordance with the plans that were set out two years ago, in May of 2022. Now, another important thing that I would like to mention is that the decision to slow down does not mean that the balance sheet will ultimately shrink by less than it would have if the pace had not been reduced. Instead, the reduction just allows the FOMC to approach the ultimate level of the portfolio more gradually. Interestingly, this is something that investors seem to understand very well, judging at least from survey results, like the survey of primary dealers or market participants that we do here at the New York Fed. But I thought it would be, I think, important to mention it anyway. Clearly, it's an important point.
Beckworth: So, just to be clear, the total amount of reduction is not going to change just because the pace has changed, correct?
Perli: That's right. Certainly, that's not the intent. The intent is simply to approach whatever a little more than ample reserves is, more gradually, to give a better chance to the system, to adjust to the lower level of reserves, to give a better chance to the existing level amount of reserves, to be redistributed appropriately across the banking system.
Beckworth: So, maybe a way to think about it, at least for me, is that we don't want to repeat 2019, where we accidentally fell back, at least temporarily, into a scarce reserve system. This way, you feel your way gently to that kink in the curve. Has the Fed thought about looking to the standing repo facility as an indicator for that point? Imagine shrinking, shrinking, shrinking, and then suddenly there's a big uptake of the standing repo facility that would be like a loud signal, "Hey, it's time to stop."
Perli: I do think that the standing repo facility is a very useful addition to our toolkit. You have to think about, if we start seeing sustained usage of the standing repo facility, well, maybe that means that the level of reserves is not what we thought it was going to be, right?
Beckworth: Yes.
Perli: Probably, if we start seeing the sustained usage, maybe we went a little bit over the slightly above ample level of reserves that the Committee intends to achieve. Conversely, I think that where the standing repo facility could be very useful is the situation where there is a one-day shock to the system that temporarily creates a scarcity of reserves, and then the SRF is there precisely for that purpose, and then the next day, we're back to normal. So, I think that short-term temporary utilization would be perfectly consistent with the Committee plans, maybe a sustained usage, maybe not.
Beckworth: Okay, so if we see a sustained use in the standing repo facility, it might be a clear signal. Now, you give some other indicators that you're looking for, to tell you when you've reached that point, in your speech. Maybe walk through those.
How to Determine the Critical Level of Reserves
Perli: So, before doing that, let me also say that the SRF, the standing repo facility, is extremely useful because, among other things, it gives certainty to the market that they can— primary dealers and banks that are counterparties to the SRF— can borrow from the Fed should there be a shortage of reserves. In the past, I think that the market had no doubt that, should there be a big dislocation in funding markets, that the Fed would intervene, but the market didn't know when, how long it would take for the Fed to intervene, and the market didn't know to what extent the Fed would intervene. So, there was a considerable amount of uncertainty, and now, because the SRF is a standing facility, that uncertainty is gone. So, I think that's a very important point.
Perli: Now, you asked, what are we going to look at to decide whether or not we're approaching the critical level of reserves? First, let me say that the Committee, in May 2022, laid out some very clear plans that said that the Committee would slow first and then stop the shrinking of the portfolio when reserves achieve a level that, in the judgment of the Committee, is somewhat above ample. Okay, so the Committee intends to stop before we get to the ample level of reserves, and, of course, that means, even more, wants to stop before we get to the scarce level of reserves, of course. So, what are we going to look at to judge how many reserves are in the system, so, whether reserves are still abundant or how close to ample they are? Well, there are many things. One obvious indicator is the spread between the effective federal funds rate and the interest rate on reserve balances, or the IORB, so, the EFFR to IORB spread.
Perli: So, at present, that spread stands at negative seven basis points. And because the effective federal funds rate has not moved at all, virtually, that spread's being completely stable. It's just that if you plot it, it's just a flat line. So, the fact that it's completely stable tells us that it's one sign, at least, that reserves are still abundant. But when, or if, or when it starts becoming less negative, at some point in the future, it should provide an important clue that reserves may be becoming progressively less abundant. So, that's definitely one thing to watch.
Perli: But even an increase in spread, like between EFFR and IORB, doesn't necessarily tell us where, along the demand curve for reserves, the financial system is operating. For this reason, I think there is value in monitoring other indicators. One other indicator that I think is very important is the elasticity of the federal funds rate to short-term shocks in the reserve supply, which you can think of as the local slope of the demand curve for reserves.
Perli: So, there is a recent research paper, by colleagues of mine here in the research department at New York Fed and John Williams, of course, the president of New York Fed, that presents some econometric techniques that can help us measure and track this elasticity over time. If you look at what this exercise tells us, well, it tells us that, currently, the elasticity is close to, and also statistically indistinguishable from zero. In other words, it tells us that the slope of the demand curve is zero, and so we're very likely to be in the flat segment of the demand curve, which confirms what the EFFR to IORB spread tells us.
Perli: So, I think that these are very important indicators that speak directly to the demand curve for reserves. Now, what we don't know for sure is exactly how abundant reserves are. Put differently, we don't know how far we are from where the demand curve starts showing a gentle local slope, or— which is the same thing— we don't know how far we are from the regional ample reserves. And importantly, we also don't know how quickly that slope increases after the inflection point, which means that we don't know exactly how gradual the transition from abundant to ample reserves will be.
Perli: So, given all of this uncertainty, I think it's very useful to try to look at a number of other indicators that can provide some clues, some information, as to how far we are from this inflection point, and also, not just provide some information, but ideally provide some leading information, so that we're looking for potentially leading indicators, because, again, remember that the Committee said that we want to stop shrinking the balance sheet when we are somewhat above the ample level of reserves. So, to try to accomplish that, we're looking at a number of other things, and I can mention the domestic bank borrowing activity in the federal funds market, I can mention the timing of interbank payments, I can mention the amount of daylight overdrafts that we see every day, and I can mention, also, the share of repo volumes that trades at or above the IORB.
Beckworth: This is very fascinating, and Roberto, it kind of reminds me of old-school monetarism. When we were younger, we would have to estimate real money demand, because you don't observe it. You don't observe the demand for a particular asset. And in this case, what you're struggling with is knowing the structural demand for reserves. Where does that kink occur in it? And so, you have to use all of these other indicators to kind of feel your way there. So, it's interesting to think about that process. Do you think that the structural demand for reserves grows over time? We have regulatory reasons [for] why it's elevated. Do you think that there's any kind of a ratchet effect? There's been some literature on this, that maybe banks depend on it, they grow comfortable. What are your thoughts on the structural demand for bank reserves over time?
The Structural Demand for Bank Reserves Over Time
Perli: Well, we know from surveys, at least, like the Senior Financial Officer Survey, that we, the New York Fed and the board, administer periodically— I think the results from that survey are pretty clear. The survey says that the lowest comfortable level of reserves that banks want to hold has increased quite significantly in the last several years. The buffers that banks want to hold above that level have increased as well. And so, on net, if you add up the two, the amount of reserves that banks want to hold, so the demand for reserves, has definitely increased over time, so that all of the information that we have points in that direction.
Perli: Of course, we don't know how much. That's part of the uncertainty. The Senior Financial Officer Survey is a relatively small sample of banks, so we cannot really extrapolate, from that sample, to the whole aggregate banking system. But we do know that the amount of reserves that the banking system demands is most likely substantially higher than it used to be in the past. And so, what we're trying to do is, we don't know exactly what this demand is, but we're trying to look at all of these indicators that I mentioned earlier to try to get the early warning signs of when we're getting somewhat closer to that level.
Beckworth: So, let me push you on that just a little bit. Do you think that that growing structural demand for reserves is simply due to the economy growing— there's more demand for money, overall— or is any of it just tied to, they've gotten used to such big balances because of QE in the various programs?
Perli: All we know for sure is that the demand for reserves— well, not even for sure— All of the indications we have is that the demand for reserve is higher, substantially higher. Certainly, the economy, the growth of the economy, is an important factor. So, the economy grows and [there are] more deposits, more deposits that can flee, and so [there are] more reserves that you need to hold against them. We also know that there have been some regulatory developments that have incentivized the holding of reserves. We also know that the banking system, just last year, not so long ago, went through some period of stress in the spring of March, April of last year. I think that that episode— again, if you look at the Senior Financial Officer Survey— might have been another catalyst for a heightened demand for reserves. So, I don't think that you have to go beyond these three— these different factors that I just mentioned to explain why the demand may be higher.
Beckworth: One of the interesting conversations that's been going on since this banking turmoil last year has been a discussion about having banks use their collateral at the discount window to meet their liquidity requirements, so, make them more able to quickly turn capital into liquidity, so that if something comes up again, like March of last year, it would make it easier to handle that stress. And there's been a lot of push for this, and I suspect that if this does become the way that things are done-- and I know there's stigma. Stigma is a big hurdle to get past. But if banks were comfortable parking the existing, and more, collateral at the discount window and using that for liquidity requirement purposes, maybe some of that structural demand for reserves might go down a bit. Is that fair?
Perli: I don't know that that's true. I think what I can tell you is that, definitely, the events of last March brought a lot of attention to the role of the discount window and the banks’ degree of readiness to utilize the discount window when facing acute stress. More specifically, I think it highlighted that having established discount window access and significant collateral pledged at the window is important, because that's an easy way for banks to face a demand for cash. So, that's very important.
Perli: So, I think that there are efforts, as you know, to try to make sure that banks— or try to incentivize banks to pledge collateral, to have all of the documents signed to be ready to access the window if needed. Recently, the Federal Reserve Board published some data as to how many banks are ready to borrow from the window, and I think that the numbers were encouraging, especially in terms of percentage of assets. Still, many banks are not ready to tap the window, but as a percentage of assets— I think 90 plus percent of the assets are covered. So, I think that that's an encouraging result. But, of course, I think more would need to be done there. But I think that this last March really drove home the point that being ready to access the window is important. We saw it very clearly. So, yes, I think that's what I can say. That's how I'm thinking about it at the moment.
Beckworth: Yes, I think it's a very promising development, to see this push towards more discount window use. Let's move to another topic related to this, and that is the Fed's operating system. So, you've used the terms ample, abundant. But I would call it a floor operating system, which is different than what the Fed used pre-2008. They had a corridor, at least an asymmetric corridor, because zero was, really, the lower bound on bank reserves, what they earn.
Beckworth: But you can think of other places like the ECB. They've had a symmetric corridor system before they've collapsed into a floor, and they've actually had talks about trying to tweak it a little bit recently. There's been a number of central banks that have talked about their operating systems, but I believe that you are very comfortable with the floor system that the Fed has. So, maybe talk to us about that. What do you see as its advantages, and why are you pleased with what it's done so far?
The Advantages of the Floor Operating System
Perli: If you're asking me, why do we have a floor system, I can give you a very simple answer. The answer is because it works very well. [It’s] as simple as that. I can elaborate on that, of course.
Beckworth: Yes, please do.
Perli: That's the gist of the message.
Beckworth: It works very well, yes.
Perli: So, as you just said, the FOMC de facto adopted a floor system during the global financial crisis. Then, importantly, in January 2019, it communicated its intent to maintain this framework, so, in January 2019, like a little more than four years ago. So, if we look at the minutes and other communications that led up to that decision, it's pretty clear why the Committee decided in favor of this floor system. The key advantages are that— or at least that were mentioned by FOMC members— are that the floor system allows for very good interest rate control in a variety of conditions, not just in normal time, but also when there is some stress in the market; so, good rate control and a good transmission of the federal funds rate to other money market rates and to broader financial markets as well.
Perli: They also said that a different framework, that controlled the policy rate through active reserve management like we had before, probably would have some disadvantages. In particular, the level and variability of volatility of reserve demand and supply in that situation were likely to be much larger today than in the period before the crisis. Stabilizing the policy rate in different environments would require large and frequent open market operations, the size of which would be very hard to get right every single time.
Perli: That would imply, basically, greater volatility in money market rates, and that's probably not desirable. Think about it, the TGA is much larger than it used to be. Currency is much larger than it used to be. The TGA, especially, is not only larger but is also much more variable than it used to be. And so, forecasting it accurately every day is a complicated task. And, maybe, many times, we would get the forecast right, but several times we wouldn't. And so, the days that we don't get the forecast right, you would see some significant swings in the funds rate and money market rates, and that, I think the Committee said, is not particularly desirable.
Perli: Conversely, if you use a floor system, the floor system aims to make sure that the Fed always supplies reserves in the amounts that the banks demand. So, there is no need to get the forecast right every single day. There is an excess supply of reserves, and so that makes things a lot easier and a lot more stable. So, that's, I think, the definition of good, strong rate control. It's also efficient [and] it's very simple to operate. Maybe, another important thing to say, is [that] this ample reserve, this floor system, also allows more variability in other Federal Reserve liabilities, such as the TGA that we just talked about, but also the foreign repo pools, deposits by the FMUs, and so on. There are other liabilities that we have. So, the ability to accommodate changes, and even large changes, in these non-reserve liabilities, I think, is important, because those liabilities provide actual and concrete benefits to the economy. So, I think that that's another important angle that sometimes people don't consider.
Perli: And finally, let me mention the fact that the floor system maintains interest rate control, also, at the same time that it allows for policies that significantly expand the Fed’s balance sheet, whether that's for policy accommodation or for market functioning purposes, or whatever other reasons, but we can maintain rate control, even when we have to expand the balance sheet a lot, like we did in, say, 2020, for example. Obviously, this has proven to be the case in 2020, 2021, 2022. So, I think there are a lot of reasons, but, again, I would summarize it: It works really well.
Beckworth: Very succinct. So, that's interesting. You mentioned that maybe some of the biggest challenges in forecasting the size of the Fed's balance sheet is the TGA and then, I guess, in crisis times, also, would be these other kind of autonomous, non-reserve liabilities, foreign repo, currency swaps. All of those things can also swing if there's something extraordinary going on, and that makes it harder, is what you're saying, if one were doing a corridor scarce reserve system. Is that right?
Perli: Yes, but I’m saying it is definitely— it's always hard to forecast anything during crisis times. There's no doubt about it. I'm saying that even during non-crisis times, forecasting the TGA is complicated. It has become a lot more complicated because it varies a lot. It's larger, much larger than it used to be. So, that's something that we don't have to worry about with the floor system. It makes things a lot simpler.
Beckworth: So, you're saying that pre-2008, swings in the TGA were much less significant. I guess we got large budget deficits as far as the eye can see. We're probably going to have more debt ceiling challenges ahead. So, the TGA is always going to be with us, it looks like, going forward. The other non-reserve liabilities, do you think their importance has also gone up, in part, because of the growth of the global dollar market? We have money markets around the world denominated in dollars, and we want to keep that stable, so we need more flexibility in addressing that?
Perli: I think that there are a lot of reasons why the variability of non-reserve liabilities has increased. You can point, certainly, to the stated objective that Treasury have to keep several days of future payments in the TGA, but there are, really, a lot of other factors. For example, as you just mentioned, we have the foreign repo pool where foreign central banks and other official institutions invest their short-term cash. So, that has grown as well, over time. The FMUs are getting bigger as well. The financial system is getting bigger, so, it's only natural that all of these other different liabilities grow over time. It's not the fault of anybody. It's just the financial system that's growing. It's getting bigger.
Beckworth: I guess, to be succinct like you were earlier, if I had to make the case for this system, it's that the global financial system, particularly the global dollar system, is getting so large, and the Fed's balance sheet is kind of endogenous to that. It has to adapt to that development. Let me throw out one critique of that system that proponents of the corridor system often bring up, and that is that the overnight, unsecured, interbank market, if I said [all of that] correctly, isn't what it used to be. The federal funds market, for example, really— it's not really what it used to be. There's GSEs in it. But you don't have a lot of overnight unsecured lending between banks. There's not this price discovery between banks in an unsecured setting. Is that the market missing a big loss, or do you think it's made up for in other ways?
Perli: The only thing I would say here is that the federal funds rate has been very stable, and not only that, but the stability— as I said at the beginning— of the funds rate has propagated to other money market rates. So, it's not that the funds rate exists in a vacuum, and who knows what the rest of the money markets are doing. What happens in the funds rate is propagated to other money market rates very efficiently and, I think, very well. So, I don't think we have, for the moment, a particular problem there.
Beckworth: So, Roberto, it sounds like, then, that the FOMC and you, yourself, are very content with the operating system that we have at the Fed, and unlike other central banks that have taken a look at their operating system— so, like the ECB, as I mentioned— for now, we're going to stick with it, and it's good to go. Is that a fair assessment?
Perli: Remember the disclaimer that I-
Beckworth: It's you.
Perli: -opened this conversation with. So, the opinions that I express here are my own and not those of the Federal Reserve Bank of New York or the Federal Reserve System. I speak for myself here. Look, this is a question you should ask policymakers, not me. I cannot front-run them.
Beckworth: Yes, I understand. Roberto, as we wrap up the show, just looking ahead, how confident are you that the Desk has a clear enough sense of whether reserve supply is abundant or ample? What are you focused on moving ahead?
Reserve Supply Focus Moving Forward
Perli: I think that we can be fairly confident that we are still very much into the abundant region of reserves. Of course, we cannot know exactly, for sure, how far we are from the ample region, but we are in the abundant region. All of our indicators tell us so. The effective funds rate spread to the IORB, the elasticity of the demand curve, all of the other auxiliary indicators that I mentioned earlier, they all agree at the moment that we are in the abundant region.
Perli: So, going forward, of course, reserves will start shrinking, slowly, starting in June, because the pace of runoff of the portfolio will be halved starting in June. But, eventually, reserves will start going down, and I think it's important that the Committee decided to slow the pace, because it allows us more time to get a sense of how close we are to the ample region, gives the system more time to adapt to a lower reserve level. So, I think that decision was very prudent and made at the right time.
Perli: So, at the moment, I'm very confident that we are still abundant. I'm very confident that the system works well. And so, we should— I expect that we will approach, smoothly, the ample region of reserves. So far, all [of the] indicators, they flash green. Let's put it that way. Of course, there are a lot of things that we don't know, so we have to be humble and respectful of that fact, and that's why we look, on a daily basis, at all of these indicators. But if, or when, these indicators change, we'll take note of that, but, for the moment, things are going very well.
Beckworth: Okay, with that, our time is up. Our guest today has been Roberto Perli. Roberto, thank you so much for coming back on the program.
Perli: David, thank you very much for having me. It's been an absolute pleasure to talk to you again. Thank you.
