A Brookings paper says the Fed could shrink its $6.8 trillion balance sheet to about $4.5 trillion by changing its liquidity tools and reducing banks’ reserve requirements. The proposal would lower reserves in the financial system from about $3 trillion to about $1 trillion.
Chris Hughes, a nonresident fellow at the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy, proposed replacing the Fed’s “ample reserves” system with an “Elastic Reserves” system that responds to market demand for cash. The changes could reduce Fed holdings from $6.8 trillion to about $4.5 trillion and reserves from around $3 trillion to about $1 trillion.
The paper proposes uncapped standing repo operations at a rate above the interest on reserves rate, a new four-month Term Liquidity Facility, and continued use of the Discount Window for emergency lending. It also recommends shifting Fed holdings toward Treasury bills, targeting the Secured Overnight Financing Rate instead of the federal funds rate, and changing banking regulations and Treasury cash management to reduce reserve demand.
The paper says the changes could reduce the Fed’s footprint as a share of GDP to its smallest since 2008 and cut interest paid to banks by roughly two-thirds. Some Fed officials and experts say the ample-reserves system effectively controls interest rates and helps banks withstand financial stress; New York Fed President John Williams called it “highly effective” in September.
