Recently, Loretta Mester (Former president of FRB Cleveland) talked about the Fed’s move from a scarce reserve framework to an ample reserve framework in a podcast. In this post, I summarize both frameworks and analyze the historical data to understand the ideal level of bank reserves required for the ample reserve framework to operate effectively.

What Is The Fed’s Monetary Operating Framework?

The Fed’s monetary policy operating framework is the central bank’s mechanism to maintain the policy rate within its target range. The Fed conveys its policy decision by establishing a target range for the federal funds rate, the average market-driven rate at which banks lend reserves from their Fed master accounts to each other overnight.

Ample Reserve (Floor) Framework: Since the 2007–2008 Global Financial Crisis, the Federal Reserve and other central banks have operated within a monetary policy framework characterized by ample bank reserves—funds held by banks in central bank accounts. In January 2019, the FOMC reaffirmed its commitment to this ample-reserves approach, or floor system, where monetary policy is implemented primarily through administered interest rates, including the interest on reserve balances (IORB) and the overnight reverse repurchase agreement (ON RRP) rates while continuing to target the federal funds rate as the primary tool for adjusting policy stance.

Scarce Reserve (Corridor) Framework: Before the GFC, the Fed operated under a scarce-reserves framework, or corridor system, where the FOMC actively adjusted reserve supply to maintain its federal funds rate target. This contrasts with the current operating framework.

Why Did The Fed Change Operating Framework After GFC?

Before the GFC, the Fed’s balance sheet was much smaller. In Jan 2007, the Fed’s balance sheet was $900 billion (compared to over $7 trillion today), with $20 billion in bank reserves. With limited reserves, the FOMC could adjust the federal funds rate by slightly altering reserve supply through open market operations involving short-term Treasury transactions. The FOMC effectively maintained the federal funds rate at its target level by pairing this with reserve demand estimates.

During the GFC and the Great Recession, the Fed started lending to banks to strengthen their balance sheets. This increased the size of the Fed’s balance sheet. By Jan 2015, the Fed’s balance sheet increased to $4.5 trillion. As assets increased, reserves simultaneously climbed, reaching a peak of $2.8 trillion in November 2014. With abundant reserves, minor changes in their supply had minimal impact on the federal funds rate, making the corridor system ineffective for policy rate control.

Theory: In theory, the ample reserve framework appears to be simple, i.e., banks needing reserves would avoid paying a rate higher than the Fed’s discount window rate, while banks with excess funds would not lend below the IORB rate, which they could earn by keeping the funds in their Fed account. However, there were multiple challenges in practice, so the Fed had to change this framework to make it work.

Challenges With The Ample Reserve Framework

Not all entities participating in short-term money markets can earn interest on reserves. Additionally, banks have hesitated to use the discount window due to its stigma. The Federal Reserve expanded its ample-reserves framework by introducing the ON RRP facility and the standing repo facility (SRF) to address this.

ON RRP (Dec 2015): The Federal Home Loan Banks, major lenders in the Fed funds market, do not earn interest on reserve balances at the Fed, prompting them to lend at any rate above zero and exerting downward pressure on the Fed funds rate. Similarly, money market mutual funds, which also do not earn interest on reserves, influence trading in the market. Since 2015, the Fed has operated the ON RRP facility to solve this issue. This facility allows money market entities to lend funds to the Fed overnight, secured by eligible securities, enabling the Fed to anchor overnight interest rates more effectively.

SRF (July 2021): As we know, the Fed discount window is stigmatized, i.e., banks hesitate to borrow from it as it’s perceived that the bank is in trouble. Again, the theoretical consideration mentioned above does not work in practice. To address this issue, the Fed started this backstop facility as an alternative to the stigmatized discount window, helping to maintain the federal funds rate below the upper target range. By enhancing the substitutability of Treasury securities for reserves in banks’ liquidity management, the SRF enables the Fed to operate within an ample reserve framework with a lower reserve level.

The Fed Balance Sheet vs. Reserves and ON RRP Balance

The table below compares the approximate—Fed balance sheet size, reserves, and ON RRP balance.

Reserve/Fed BS % = Shows the % of reserves vs. Fed balance sheet

Total/Fed BS % = Shows the % of total (reserves + ON RRP balance) vs. Fed balance sheet

Since the Fed implements the ample reserve or floor framework, the total % (Reserve + ON RRP) is comfortably over 60% for most of the period. Also, the reserves are generally around $3 trillion. In Sep 2019, when this total % fell below 40 (~$1.4 T), there was a disruption in the market with a spike in the repo and other short-term money market rates. The market disruption prompted the Federal Reserve to recognize that reserve levels had dropped below those consistent with ample reserves, leading it to resume increasing reserve balances. Hence, the reserve levels dictate the course of quantitative tightening or the balance sheet reduction policy of the Fed.

Drawbacks Of The Ample Reserve Framework And Possible Enhancement

One of the criticisms of the ample reserve framework is that it discourages banks from lending in the overnight funding market as banks earn risk-free returns on their reserve. Due to this, the central bank may need to intervene more often to calm the market. One solution to this is the tier-based approach followed by the Norges Bank and the Swiss National Bank, where the interest rate is lowered as the quantity of reserve goes up to incentivize banks to lend in the overnight funding market.

NY Fed Reserve Demand Elasticity Tool:

The reserve demand elasticity tool gauges the elasticity of the federal funds rate to reserve changes. In March, the Fed began reducing its balance sheet, now down to $6.9 trillion, by allowing up to $25 billion in Treasuries and $35 billion in mortgage-backed securities to mature monthly without reinvestment. This reduces banking reserves, which provide a risk-free return and influence the federal funds rate, now at 4.25%-4.5% after recent cuts.

Reserves remain “abundant,” according to the New York Fed’s Reserve Demand Elasticity tool, allowing the Fed to continue quantitative tightening with minimal impact on rates.

Timeline: