MNI: Fed Repo Operations Would Shrink Balance Sheet - Duffie

Active repo operations by the Federal Reserve to dampen spikes in demand for bank reserves on key dates would allow the central bank to keep a smaller balance sheet overall, a preferred policy goal of Kevin Warsh, President Trump's pick for Fed chair, according to Stanford University economist Darrell Duffie. 

In research to be presented at a Brookings Institution conference Thursday, Duffie finds temporary open market operations and liquidity regulation reform to be easier ways to shrink the Fed's balance sheet by lowering banks' demand for reserves. 

Other harder -- but more impactful -- options would be retooling the Fed's payment system and reducing the interest rate paid on reserve balances once banks exceed the amount needed to conduct their business operations, Duffie found. The legality of the latter idea is unclear, he said. 

All policy options to shrink the balance sheet, while keeping the Fed's ample reserves policy implementation framework, require reducing banks' demand for reserves, else risk wild fluctuations in money market rates, Duffie told reporters. 

"You could pick off one or two of these and have a little effect. If you want to have a lot of effect, it's going to be quite a lot of work," he said. "If you don't do any of the other things on my list, then I think the Fed would find that the volatility would be excessive."  

TOMOS

The Fed could sterilize supply fluctuations from increases in the Treasury General Account or Foreign and International Monetary Authorities reverse repo pool and end-of-quarter window dressing by foreign banks by conducting offsetting repo operations, Duffie said. 

These daily or weekly operations could extend as much as USD300 billion at a time, and special quarter-end or year-end operations could take the form of standing repo operations that accept bids as low 5 or 10 basis points below IORB, compared with the normal price of 10 bps above IORB, Duffie noted.     

"That would be a pretty active role for the Fed, and there's a view amongst some in the Fed that I’ve spoken with that say, 'Well, we don't want to be that active. We want to be steady on our market operations, not all over the place every day moving up and down to fill in these potholes,'" Duffie said. 

"My comeback on that would be, you could either be steady on your operations -- just add constant amounts like the Fed is doing now at USD40 billion a month -- and get a bumpy path of balances in the system, or you could do bumpy operations and get a smooth path of total reserve balances in the system. I would go for the latter." (See: MNI POLICY: Long Road To Scarcer Reserves For Fed Nom Warsh)

LIQUIDITY REFORM

Post-financial-crisis liquidity regulations and their supervision have also had the consequence of increasing the quantity of reserve balances necessary to run the payment system, because large banks are not willing to access Fed facilities to increase reserves when needed, Duffie said. 

Reversing disincentives for these banks to rely on Fed daylight overdrafts, the discount window and the standing repo operations could bring down reserves demand, he said. For example, the Fed could order its supervisors to "go easy on banks when they do an overdraft in the middle of the day," Duffie said. 

The Fed's regulation chief, Governor Michelle Bowman, alongside Treasury Secretary Scott Bessent this month previewed plans to recalibrate liquidity regulations.     

Bessent suggested regulators could reduce discount window stigma by requiring banks to use it in order to count access to the discount window toward meeting their liquidity regulation, an idea Duffie said he liked.