The new monetary policy regime under central bank’s abundant balance sheet: the case of the Federal Reserve

Abstract

Purpose The transmission of monetary policy has received considerable attention due to the sizable enlargement of the Federal Reserve’s balance sheet and consequently of the large reserve balances held by the Depository Institutions. This paper aims to investigate whether changes in the quantity of the reserve balances during the so-called normalization period and the COVID-19 crisis put significant pressure on short-term interest rates and specifically on the Effective Federal Funds rate (EFFR). Design/methodology/approach Under the new monetary policy regime, with two newly administered interest rates, the authors use the spread of the Federal Funds rates and the Interest on Reserve Balances (as a measure of the price of liquidity. With the means of various models such as the structural vector autoregression, the authors investigate, for two different subsample periods, the effectiveness of the monetary policy and the creation of (any) liquidity effects. Findings The results showed that when the Fed decreases its balance sheet size, during the normalization period, significant liquidity effects are present meaning that the authorities could influence the stage of the short-term interest rates under the new monetary policy regime. However, this relationship appears to weaken considerably as the level of reserve balances, particularly in response to the COVID-19 pandemic, increases substantially. The authors enriched the findings by highlighting the role of the benchmark repo rate. During the COVID-19 period, and in light of abundant reserve balances, the repo rate reacts more vigorously to a reduction in reserves, whereas an increase in the repo rate seems to exert a strong positive influence on the EFFR. Originality/value The findings are very important for the efficiency of the monetary transmission mechanism. An expanded balance sheet is still considered an arcane concept in regard to the structure and its effects on monetary policy implementation. This is one of the only few studies that investigates the effect of the abundant reserve balances on the short-term interest rates for two different in nature subsample periods. It shows as well the interplay between short-term interest rates, secured and unsecured.