Federal Reserve officials pledged to reduce the size of the central bank’s record balance sheet as they continued to map out a strategy to exit from the most aggressive monetary stimulus in its 100-year history.
“In the long run, the balance sheet should be reduced to the smallest level consistent with efficient implementation of monetary policy and should consist primarily of Treasury securities” in order to minimize the effect of the Fed’s portfolio holdings on credit allocation across different sectors of the economy, according to the minutes of the Federal Open Market Committee’s July meeting released today.
Almost six years of Fed bond buying to support a recovery from the worst recession since the Great Depression has flooded the banking system with $2.71 trillion of excess reserves. Because banks no longer need to borrow reserves from each other as they did before the crisis, officials have been forced to come up with a new way to raise the federal funds rate, which represents a bank’s cost of overnight borrowing.
The July meeting minutes provided further clues as to how they plan to do so.
The rate of interest the Fed pays on excess reserves held at the central bank -- now 0.25 percent -- “would be the primary tool used to move the federal funds rate into its target range and influence other money market rates.” The rate the Fed sets on its reverse repurchase facility, a program it has been testing since last year to soak up cash from money-market mutual funds and other counterparties, would set a floor under the fed funds rate.
In an overnight reverse repo, the central bank borrows cash from counterparties using securities as collateral. The next day, the Fed returns the cash plus interest to the lender and gets the securities back. It currently pays 0.05 percent interest on the cash it borrows through the reverse repurchase program.
The Fed will need to rely on the reverse repurchase facility to put a floor under market rates until the central bank achieves its long-term goal of returning the $4.43 trillion balance sheet to a more normal size, a process that could take 10 years, said Aneta Markowska, chief U.S. economist at Societe Generale SA in New York.
Fed officials generally agreed that the reverse repo facility would play a “temporary” role in the conduct of monetary policy, “and should be phased out when it is no longer needed for that purpose,” the minutes showed.
“It might take as long as 10 years to get rid of all of the excess reserves in the system, and until then, they have no choice but to use the reverse repo facility if they really want to set a floor under the fed funds rate,” Markowska said. “Temporary sounds very temporary, but it may not be. That facility may be with us for a while.”