Fed study details options for balance sheet reduction via reserve demand

The paper presents a suite of policy options for reducing the Federal Reserve's balance sheet, many of which aim to reduce the demand for reserves.

It directly challenges the common view that the Fed cannot materially shrink its balance sheet from current levels due to a steeply sloped reserve demand curve.

Instead, the authors argue that reserve demand is significantly influenced by the regulatory environment, encompassing formal requirements and supervisory expectations for high-quality liquid assets.

This "regulatory dominance" allows for policies explicitly designed to reduce reserve demand through regulatory and other tools.

Such an approach enables further reductions in reserve supply without creating unwanted stresses in short-term funding markets.

The study estimates these options could lead to a balance sheet reduction of $1.2 to $2.1 trillion within the current ample reserves framework.

The study outlines 15 policy options, categorized into reducing equilibrium reserve demand and liabilities outside the domestic banking system.

These include recognizing Discount Window capacity in the LCR, recalibrating LCR requirements during stress periods, and implementing a liquidity savings mechanism for Fedwire.

Other options address Treasury General Account management and discouraging the use of the Foreign Reverse Repo Pool.

The paper also distinguishes between scarce, ample, and abundant reserve regimes.

The authors caution that materially shrinking the balance sheet would require extensive implementation work and could take at least a year, possibly several, before the Fed could begin the process.