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Quarles, Randal on 2018 May 4 at 17:30

What will the Fed be monitoring as reserves are drained and the balance sheet shrinks? I would first like to emphasize that the Fed regularly monitors financial markets for a number of reasons, so I do not mean to imply that we will be doing anything that is very much different for our normal practice. As reserves continue to be drained, we will want to gauge how banks are managing their balance sheets in continuing to meet their LCRs, watching in particular how the distribution of reserve balances across the banking system evolves as well as monitoring any large-scale changes in banks' holdings of other HQLA-eligible assets, including Treasury securities and agency mortgage-backed securities. And on the liabilities side of banks' books, we will be keeping our eye on both the volume and the composition of deposits... Of course, importantly, deposits will not necessarily decline one-for-one with reserve balances as the Fed's balance sheet shrinks. The overall effects of the decline in the Fed's balance sheet will depend both on who ultimately ends up holding the securities in place of the Fed and on the full range of portfolio adjustments that other economic agents ultimately make as a result. We will also be monitoring movements in interest rates. In part, we will be tracking how the yields and spreads on the various assets that banks use to meet their LCR requirements evolve. For example, to the extent that some banks will wish to keep meeting a significant portion of their LCR requirements with reserves, the reduction in the Fed's balance sheet and the associated drop in aggregate reserves could eventually result in some upward pressure on the effective federal funds rate and on yields of Treasury securities. This situation could occur if some banks eventually find that they are holding fewer reserves than desired at a given constellation of interest rates and, in response, begin to bid for more federal funds while selling Treasury securities or other assets. Interest rates will adjust up until banks are indifferent with regard to holding the relatively smaller volume of reserves available in the banking system.

Of course, importantly, deposits will not necessarily decline one-for-one with reserve balances as the Fed's balance sheet shrinks. The overall effects of the decline in the Fed's balance sheet will depend both on who ultimately ends up holding the securities in place of the Fed and on the full range of portfolio adjustments that other economic agents ultimately make as a result. Quarles, Randal

Stanford University

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