Market-Based Indicators on the Road to Ample Reserves

January 31, 2025

Market-Based Indicators on the Road to Ample Reserves¹

James A. Clouse, Sebastian Infante, and Zeynep Senyuz

"Over time, the Committee intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its ample reserves regime. To ensure a smooth transition, the Committee intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves. Once balance sheet runoff has ceased, reserve balances will likely continue to decline for a time, reflecting growth in other Federal Reserve liabilities, until the Committee judges that reserve balances are at an ample level."

Excerpt from Plans for Reducing the Size of the Federal Reserve's Balance Sheet, May 2022.

1. Introduction

As noted in the excerpt above, the FOMC's Plans for Reducing the Size of the Federal Reserve's Balance Sheet envisioned a methodical approach to balance sheet normalization in which the passive runoff of securities holdings would stop when reserves levels are "somewhat above the level it judges to be consistent with ample reserves." Once balance sheet runoff stops, reserve balances would continue to decline with the growth of non-reserve liabilities for some time until they reach ample levels. The SOMA portfolio would then start growing with reserve management purchases in line with the growth in non-reserve liabilities. In light of lessons learned during the 2017-2019 balance sheet normalization, the Committee was mindful of the uncertainties surrounding estimates of the demand for reserves and sought to follow a process that would allow for careful monitoring of market conditions in determining when to "slow and then stop" balance sheet runoff.² The process of balance sheet runoff has proceeded very smoothly to date. The Federal Reserve's securities holdings have declined by nearly $2 trillion since the beginning of balance sheet runoff. As noted in a recent speech by Roberto Perli-the current manager of the System Open Market Account-a range of key metrics suggests that reserves remain abundant with few if any signs of significant market pressures of the type observed over 2018 to 2019.³ Still, as Perli noted, the Federal Reserve continues to closely monitor a wide range of market indicators as well as information gleaned from surveys and contacts with market participants in assessing reserve market conditions during the transition to ample reserves.

This note reviews a few basic market-based indicators that may be helpful in assessing overall reserve market conditions as the balance sheet runoff process continues. The aim is to focus on indicators that are readily observable, and thus may be useful to the public in tracking progress toward "ample" reserve conditions. The remainder of this note is organized as follows. Section 2 provides some background on the evolution of the Federal Reserve's balance sheet over recent years including experience with balance sheet normalization over the period from 2017-2019. Section 3 provides a stylized analytical framework that is useful in thinking about the linkages among the various market indicators and the level of reserves in the banking system. Section 4 discusses the details associated with four market indicators that provided important advance signals of tightening reserve conditions in the 2017-2019 period including: (a) the spread of the effective federal funds rate (EFFR) relative to the interest on reserve balances (IORB) rate; (b) a simple measure of the "slope" of the reserve demand curve; (c) the spread of rates on Treasury repurchase agreements (repo) relative to IORB; and (d) volatility in money market rates. All of these measures can be readily observed or calculated from publicly available data. Section 5 offers a few concluding remarks.

2. Background

A brief review of the evolution of the Federal Reserve's balance sheet helps to set the stage for the analysis below. Large scale asset purchases conducted as part of the Federal Reserve's response to the 2007-09 Global Financial Crisis (GFC) and its aftermath resulted in a very large expansion of the Federal Reserve's securities holdings and a corresponding increase in the supply of reserves in the banking system. In addition, the FOMC lowered the target range for the federal funds rate to the effective lower bound (ELB) at the end of 2008 and held it there until the end of 2015. When the Committee judged that it was appropriate to begin removing policy accommodation, it faced the challenge of raising the level of short-term interest rates at a time when reserves in the banking system stood at about $2.5 trillion-a level far above what many judged to be the underlying aggregate demand for reserves. In raising the level of interest rates in this environment, the Federal Reserve relied on two key administered rates-the interest rate on reserve balances (IORB) and the offered rate on overnight reverse repurchase agreement operations (ON RRP)-to keep the federal funds rate in the target range established by the FOMC.⁴ This was an entirely new approach to monetary policy implementation in the United States, and it worked remarkably well in providing excellent interest rate control even with very large quantities of reserves in the banking system.

Following many years of experience implementing monetary policy in a framework relying on administered rates along with extensive analysis and deliberations, the FOMC announced in January 2019 that it would continue operating in this framework on a permanent basis. In this ample-reserves regime, interest rate control is achieved primarily through the setting of the Federal Reserve's administered rates; the Federal Reserve aims to keep the aggregate level of reserves at an "ample level" that provides a cushion against shocks to the demand and supply of reserves. However, daily fine tuning of the supply of reserves as in the scarce reserves regime in place prior to the GFC is not needed.

Over the course of 2017 to 2019, the Federal Reserve gradually reduced the size of its balance sheet with the aim of returning reserves to an "ample" level. As discussed in more detail below, the balance sheet normalization process was accompanied by a gradual increase in the level of the federal funds rate relative to IORB and an associated increase in the volatility of the federal funds rate. In September of 2019, the confluence of several factors including a sharp drop in reserves, portfolio adjustments associated with corporate tax payments, and pressures stemming from a sizable settlement of Treasury securities resulted in a spike in repo rates with pressures spilling over into the fed funds market. The FOMC directed the Desk to conduct repo operations to address pressures in financing markets and to purchase Treasury bills over subsequent months to increase reserves to the "ample" level prevailing in early September. The process of adjusting the SOMA portfolio to keep reserves at a level consistent with an ample reserves regime continued throughout the remainder of 2019 and into early 2020.

The onset of the pandemic in 2020 brought a return trip of the federal funds rate to the ELB and another round of large scale asset purchases. As the economy recovered, the Fed began the process of reducing the size of its balance sheet in June of 2022. In its Plans for Reducing the Size of the Federal Reserve's Balance Sheet, the FOMC indicated that it intended to slow and then stop balance sheet runoff at a point when reserves remained somewhat above levels consistent with the ample reserves operating framework. Thereafter, a gradual reduction in reserves stemming from the trend growth of the Federal Reserve's non-reserve liabilities would slowly return the level of reserves to the "ample" region.

At present, as noted by Perli (2024), many key indicators suggest that reserves remain abundant. That assessment aligns well with results from the September Senior Financial Officer Survey which suggested that the aggregate level of reserves in the banking system remained significantly above banks' "preferred" level of reserves.⁵ Moreover, the level of reserves remains above some empirical estimates of the demand for reserve balances.⁶ Looking ahead, market participants seem to anticipate that balance sheet runoff may end before too long. For example, most respondents to the Desk survey of primary dealers conducted ahead of the November 2024 FOMC meeting anticipated that balance sheet runoff might conclude at some point by the middle of 2025. Against this backdrop, the Federal Reserve is closely monitoring a wide range of indicators for any early signs of increased competition for reserves similar to those observed in 2018 and 2019.

3. A Stylized Analytical Framework

Before turning to specific indicators, it may be helpful to review a stylized analytical framework in thinking about the changes in market conditions that would be expected to accompany the transition to ample reserves. In simple bank optimizing models that include a role for reserves in providing "liquidity services," one key optimizing condition emerges to characterize trading in the market for reserves (fed funds) and another that characterizes spill overs to other overnight funding markets, such as repo.⁷ In principle, the optimal scale of the bank's balance sheet is determined at the point where the all-in marginal return in holding reserves is equated with the bank's all-in marginal cost of funding. The all-in marginal return in holding reserves is equal to the explicit interest rate on reserve balances plus the marginal liquidity value of reserves (MLVR) in providing liquidity services. The bank's marginal funding cost can be expressed as the rate on overnight funding plus a marginal balance sheet cost.⁸ Thus, a bank optimizing condition for participating in the fed funds market can be expressed as:

$$$$ IORB+MLVR=EFFR+Marginal Balance Sheet Cost\ (1) $$$$

Equation (1) reflects the bank's decisions regarding the optimal scale of the firm. In this expression, the marginal benefit of holding an additional dollar of reserves must be equal to the marginal cost of raising an additional dollar of funding, which in turn is the sum of the EFFR and the marginal balance sheet cost associated with raising an additional dollar of funding.

The key unobserved element in equation (1) is the MLVR. Often, the MLVR is posited to be some decreasing function of the quantity of reserves held. That is, for a representative bank, when the level of reserves held is very high, the value of liquidity services provided by the last dollar of reserves is very low. And conversely, when the bank's level of reserves is limited or scarce, the value of liquidity provided by the last dollar of reserves is very high. Intuitively, the MLVR reflects precautionary demand for a bank that holds a reserve buffer to guard against large outflows. With the MLVR expressed as a function of the level of reserves, equation (1) can also be viewed as describing an individual bank's "reserve demand curve." Under the representative bank assumption, equation (1) represents an equilibrium condition for the reserves market.

Banks' optimal participation in the fed funds market also affects their participation in other overnight markets. Under the assumption that banks can lend their reserves into other overnight markets, banks optimal asset allocation requires that the bank's all-in (risk-adjusted) marginal return is equated across assets. Because the left-hand side of equation (1) characterizes the return from holding an additional dollar of reserves, it should be equal to the return in other overnight funding markets, such as repo, which is another risk-free overnight instrument for a bank as an alternative to holding reserves, as shown in equation (2):⁹

$$$$ Bank Lending Rate on Repo=IORB+MLVR\ (2) $$$$

Equation (2) just says that the bank's marginal benefit in investing an additional dollar in overnight repo must be equal to the marginal cost of sacrificing a dollar in reserve holdings. The marginal cost of reducing reserves to fund additional repo consists of the loss of explicit interest (IORB) on reserves and the loss of the marginal nonpecuniary return on reserves captured by the MLVR.¹⁰ Equations (1) and (2) together link the rate at which banks are willing to lend in repo transactions to the cost of borrowing in the fed funds market, i.e., EFFR plus the bank's marginal balance sheet cost. This relationship is suggestive of the potential for connections and spillovers between the repo market and the fed funds market.¹¹

Figure 1 provides a stylized representation of the demand curves for repo and federal funds that stem from the optimizing conditions in equations (1) and (2) when the MLVR results in a smooth shape for the reserve demand curve that becomes progressively "flatter" with higher levels of reserves. The left panel characterizes the equilibrium condition that equates banks all-in marginal return (i.e., equation 2) when reserves are "abundant," and thus, the MLVR is near zero. An optimizing bank would then be willing to lend in repo markets only at a rate just slightly above the IORB.¹² Similarly, as shown in the right panel, the bank would be willing to pay a rate to borrow in the fed funds market that is just a little above the level of the IORB rate less the bank's marginal balance sheet cost (the dotted line). In both panels, as the level of reserves declines, the MLVR becomes larger, increasing the necessary compensation to participate in either market. The optimizing conditions then suggest that banks will be willing to pay higher levels of the federal funds rate relative to IORB reflecting the higher MLVR. In addition, banks will require higher repo rates relative to IORB to lend in repo markets. The upshot of this analysis is that as reserves become less abundant, the MLVR should increase, and that should result in upward pressure on the spreads of the federal funds rate and the rate at which banks lend in repo markets relative to IORB.

Figure 2 provides some insights regarding the relationships among these spreads, the slope of the demand curve, and the volatility of money market rates. As drawn, the MLVR moves higher and the curve becomes gradually steeper as the level of reserves declines. As a result, in this diagram, there is a direct connection between the level of the spread of the EFFR and repo rates relative to IORB and the slope of the demand curve, all else equal. In this framework, a higher EFFR to IORB spread and a higher repo rate to IORB spread imply a larger MLVR and hence a steeper demand curve, and vice versa. A corollary of this observation is that there is also a direct connection then between these spreads and the volatility of money market rates. For example, as shown by the light blue shaded regions to the right in each panel, when the average level of reserves is relatively high, the spreads are narrow and the slope of the demand curve is flat. That implies then that variation in the supply of reserves (shown by the blue shaded area) results in relatively little variation in the repo rate or the federal funds rate. As the level of reserves declines, the MLVR moves higher, resulting in higher repo rate and EFFR spreads relative to IORB. Moreover, the demand curve becomes steeper. As a result, as shown by the light red shaded regions, the federal funds rate and the rate at which banks will lend in the repo market become more sensitive to fluctuations in reserve supply.

The basic conclusion from figures 1 and 2 is that "ample reserve" conditions should look more like the blue shaded regions in the left and right panels of figure 2 than the red shaded regions. While this characterization in the blue shaded regions is also true in an environment with abundant reserves, this framework suggests that if conditions are as in the red shaded regions, reserves have become too scarce. In the blue shaded regions, the spreads of repo rates and the EFFR relative to IORB will be relatively low, the slope of the demand curve will be relatively flat, and the volatility of money market rates in response to variations in reserve supply will be relatively low. So, it would appear that "all that's needed" to effectively navigate the transition from abundant reserves to ample reserves is a good estimate of the demand curve, or in other words, the MLVR. However, that is a challenging task! Even in the simple world of models, there can be many complications if the MLVR does not result in a smooth, stable shape for the demand curve shown in figures 1 and 2. Indeed, banks are very heterogenous in their approach to reserve management, and there are many reasons the MLVR may not be as well behaved as assumed above.

Afonso et al. (2023) explore the implications of a model in which the demand curve includes three segments that can be driven by independent forces. In that type of framework, the very close connection described above between the level of reserves, the slope of the demand curve, the level of spreads, and the volatility of money market rates is more complicated than discussed here. Moreover, empirical estimates of the reserve demand curve such as Lopez-Salido and Vissing Jorgenson (2024) are very helpful but typically find that the confidence intervals around point estimates of reserve demand are very wide. That may not be surprising given the structural changes over recent years that may be contributing to underlying reserve demand including changes in liquidity regulations and periods of market stress that influence how banks assess their need for liquidity to meet various contingencies. Moreover, in the current environment, the rate of return on reserves relative to other market rates can influence the desired quantity of reserves to a far greater extent than under the scarce reserves regime in place prior to the GFC. Faced with such uncertainties, reviewing indicators of reserve market conditions that can be readily observed in real time seems very important in gauging the proximity of reserve levels to the goal of "ample" reserves.

4. Market Indicators for Assessing the Ampleness of Reserves

In this section, we review the details of four key market-based indicators that may be useful in assessing evolving reserve market conditions based on the experience with balance sheet normalization from 2017-2019. Consistent with the analytical framework discussed above, the indicators reviewed here focus on key spreads, the slope of the demand curve, and the volatility of market rates.

4a. EFFR-IORB Spread
The fed funds market is a market where banks borrow unsecured funds, mostly on an overnight basis, and most of which are currently supplied by Federal Home Loan Banks (FHLBs).¹³ The effective federal funds rate (EFFR) is calculated as a volume-weighted median of federal funds transactions and generally provides a good measure of the overnight cost of unsecured borrowing for banks.

As shown in figure 3, in the 2017-2019 balance sheet runoff episode, the EFFR-IORB spread was one of the first indicators signaling increased competition for reserves. Just as the simple analytical framework discussed above would suggest, this spread started to tighten in March 2018 as the level of reserves in the banking system trended lower. Other factors such as the substantial increase in Treasury issuance, and the resulting increase in Treasury bill and repo rates likely also contributed to the upward pressure on EFFR at that time. As the EFFR moved up to and then above IORB in early 2019, daily variability in the EFFR increased-again a result one might expect from the discussion of figures 1 and 2.¹⁴

As of late 2024, the relatively low and stable EFFR-IORB spread suggests that the marginal liquidity value of reserves remains quite low. As the aggregate level of reserves declines, one might expect the MLVR to increase and become a bit steeper. Banks may then tend to bid more aggressively in funding markets to maintain or acquire reserves, and this dynamic should lead to upward pressure on EFFR relative to IORB.

4b. Estimate of the Slope of the Reserve Demand Curve
Another approach to gauge reserve ampleness is based on estimating the slope of the aggregate demand curve for reserves. As noted above, theoretical models that characterize the relationship between overnight interest rates and the level of aggregate reserves generally predict that, as reserve levels decline, the responsiveness of rates to changes in reserve supply increases as reflected in the steepening of the reserve demand curve.¹⁵ As a simple way to measure the sensitivity of the federal funds rate to changes in reserves, one can estimate a rolling regression, as shown in Equation (3):

$$$$ \Delta (VWAFF_{t} - IORB_{t}) = \alpha + \beta \Delta (Reserves_{t}) + \epsilon_{t}\ (3) $$$$

where $$VWA FF_{t}$$ is the daily volume-weighted average rate across all fed funds transactions. The reason for using the volume-weighted average fed funds rate instead of the EFFR which is the volume-weighted median is that the average rate has more variation than the median and can capture more of the variability in the distribution somewhat earlier than the median rate.¹⁶

While Equation (3) can be estimated using daily data on the VWA FF rate and reserves, one drawback of this approach is that these daily series are not publicly available, and thus, indicators based on these data cannot be monitored by market participants to assess reserve conditions in real-time. Therefore, we propose an alternative estimation based on publicly available data that yields qualitatively similar results. Specifically, using the 1st, 25th, 50th, 75th and 99th percentile of daily fed funds trading published by FRBNY, we construct a proxy for the VWA FF rate which we call the $$Est. VWA FF_{t}$$ and then calculate weekly averages. We then re-estimate equation (3) using the weekly average of $$Est. VWA FF$$ and the weekly average level of reserves balances published in the H.4.1 release.¹⁷

Figure 4 shows the estimated slope of the reserve demand curve since 2017 using both the daily measure and the publicly available weekly measure. Panel B zooms into the 2017-2019 balance sheet runoff episode to show that the slope of the reserve demand curve based on the daily data became significantly negative as early as January 2019 and remained negative leading up to the September 2019 stress episode, indicating that rates were becoming more sensitive to the decline in reserves. As shown in Panel C this estimate has been hovering around zero since the start of balance sheet runoff in June 2022, suggesting that reserves are still abundant.

Using a more sophisticated approach Afonso et al. (2024a, 2024b) provides an estimate of the slope of the demand curve based on a structural time-varying econometric model that can control for various types of shifts in the demand curve, coined the Reserve Demand Elasticity.¹⁸ The weekly estimate we propose using publicly available data yields similar results to those based on high frequency data. As shown in Panel B, the slope of the demand curve began to turn negative towards the end of 2019 Q1, a little later than indicated by the daily measures. The slope measure estimated using observable weekly data is also statistically insignificant as of late 2024, indicating that the weekly average rate in the fed funds market has not yet been moving with changes in reserves, that is reserves remain on the flat portion of the reserve demand curve.

4c. Repo Spreads to IORB
Secured overnight money market rates such as the Secured Overnight Financing Rate (SOFR) and the Triparty General Collateral Rate (TGCR) would be expected to trade near EFFR given that fed funds and Treasury repos are generally very low-risk overnight investments. In the analytical framework discussed above, the rate at which banks are willing to lend in repo markets should be just a bit above the level of the IORB by a factor reflecting the bank's marginal liquidity value of reserves. Of course, the SOFR and TGCR are based on very large samples of market transactions, and many of these transactions do not involve banks. Other factors such as the financing demand for longer-term Treasury securities or an increase in the supply of alternative short-dated instruments such as Treasury bills exert upward pressure on these rates.¹⁹ In effect, borrowers and lenders active in both fed funds and repo markets (e.g., domestic banks and FHLBs) would alter their portfolio allocations taking into account the totality of their investment opportunity set. As the payoff of alternative investments or costs of funding increase in money markets more broadly, activity in the fed funds market will be affected as both marginal lenders and borrowers react to the higher level of short-term rates, leading to potential spillovers into the fed funds market.

Distinguishing between rate movements that are attributable to supply and demand imbalances in the repo market versus those that may reflect the effects of declining reserves may not always be easy in real time. That said, figures 1 and 2 suggest that depository institutions should become less willing lenders in repo markets as the marginal liquidity value of reserves moves higher. Moreover, persistent upward pressure on repo rates has the potential to drag EFFR up even as reserves appear to remain more than ample based on other indicators.

As shown in figure 5, the 15-day moving average of both SOFR and TGCR started to rise in the spring of 2018 just several months after balance sheet runoff had started at a very gradual pace. At that early phase of balance sheet runoff reserves were still at abundant levels. The increase in the repo rates as well as other rates during that time was attributed to the substantial increase in Treasury bill issuance which pushed up Treasury bill yields and put upward pressure on money market rates in general. In September 2019, tax payments and the settlement of Treasury auctions drained a large amount of reserves and led to a mismatch of demand for repo to finance Treasury securities and the supply of repo financing. The upward pressure on repo rates at that time may have been amplified by inelastic demand for overnight funding as well as market frictions such as repo market segmentation. The experience from the September 2019 episode demonstrated that market stress can arise suddenly and spill over to the fed funds market challenging rate control.²⁰

In the current episode, as shown in Panel C of figure 5, repo rates have been gradually rising since 2023 but are still trading well below IORB. The SOFR spread has been modestly tighter than the TGCR spread, likely due to the fact that SOFR includes a broader set of Treasury repo transactions than TGCR, including those that reflect intermediation costs and market segmentation.

Beyond this trend of gradually increasing rates this year, repo rates have started showing higher sensitivity on days with large Treasury issuance as well as on quarter-end days which are also financial reporting days for most dealers that are active repo borrowers. Such temporary pressures on repo rates on quarter-end and year-end dates primarily reflect financial intermediaries' balance sheet constraints rather than shortfalls in the aggregate supply of reserve balances. However, as noted in the analytical framework above, lower levels of reserves in the banking system can make banks less willing lenders in repo markets, and that could be a factor contributing to upward pressure on repo rates on reporting dates. Monitoring these dynamics and gauging the extent of cash-collateral imbalances in the repo market is important as such pressures are expected to intensify with a decline in reserve balances and thus may provide some early signs of reserves becoming less ample. In particular, the September 2024 quarter-end did exhibit significant widening of repo rate spreads, with some usage at the standing repo facility (SRF).²¹ Taken together, these observations suggest that while reserves remain more than ample as of late 2024, ongoing balance sheet runoff may be starting to move the level of reserves into a slightly "less flat" region of the reserve demand curve.

4d. Volatility in Money Markets
As discussed above, volatility in money market rates would be expected to increase when reserves fall to a point at which there is a more pronounced upward slope of the reserve demand curve. Figures 6 and 7 show the 15-day rolling standard deviation of the EFFR-IORB spread and repo rate spreads to IORB, respectively. Starting in mid-2018, trading in money markets became consistently more volatile compared to the prior period as rates moved above IORB. The volatility increased further leading up to the end of balance sheet runoff in July 2019 and the subsequent stress emerged in money markets in September 2019. The two outsized spikes are associated with the September 2019 events and the stress episode in March 2020 related to the COVID-19 pandemic.

Volatility has been quite subdued in the fed funds market since the beginning of balance sheet runoff in June 2022, as indicated by the mostly flat line since then. While the repo rates exhibited more variability compared with EFFR during the same period, volatility patterns have remained largely stable both for SOFR and TGCR rates.

5. Conclusion

To summarize, all of the market-based indicators of reserve conditions discussed above point to reserve levels remaining comfortably on the "flat portion" of the reserve demand curve. Based on the experience over the 2017-2019 period, this set of readily observable market indicators may provide a useful means of monitoring reserve market conditions as the level of reserves continues to decline. Of course, U.S. money markets are complicated and no single indicator or set of indicators is likely to capture every aspect of the evolution of reserve market conditions. Moreover, there is no guarantee that conditions in reserve markets and money markets will evolve exactly as in the 2017-2019 period. For this reason, it is important to monitor a wide range of indicators and to supplement this quantitative information with more qualitative information gained through surveys and market outreach.

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