Federal Reserve's New Approach to Balance Sheet Reduction! Logan proposes "reducing demand" as an alternative to tightening liquidity

Zhitong Finance APP learned that as the Federal Reserve’s policy framework continues to be debated, Dallas Fed President Logan said that the U.S. central bank could reduce banks’ demand for reserves by adjusting regulatory rules, thereby shrinking the balance sheet, without returning to a “scarce reserves” system.

In a speech, Logan pointed out that the current “ample reserves” framework remains efficient and effective, and over the past nearly 20 years has proven that it can stabilize money market interest rates within the target range set by the Federal Open Market Committee (FOMC). Therefore, compared with reverting to the pre-financial-crisis model, “moving the demand curve inward” by reducing banks’ reliance on reserves is the better option.

In recent years, the size of the Federal Reserve’s balance sheet has become a focus of policy discussions. Since the financial crisis and during the pandemic, when the balance sheet was expanded through large-scale asset purchases, how to reduce the balance sheet in a reasonable manner has become a key concern for officials and some legislators. Although most views hold that the balance sheet can be further shrunk, there remains significant disagreement over the specific path.

For example, Kevin Warsh, a potential Federal Reserve chair nominee put forward by U.S. President Trump, has said that reducing the balance sheet size could open up room for future rate cuts. Logan and her team, however, proposed various technical paths in related research, focusing on optimizing institutional design rather than simply tightening liquidity.

Logan believes that by streamlining certain liquidity regulatory rules, banks’ demand for reserves can be lowered. At the same time, adjusting emergency lending tools such as the discount window can improve the efficiency of liquidity use. In addition, she also affirmed the role of the Federal Reserve’s existing short-term funding mechanism in improving intraday liquidity.

That said, she emphasized that reserves held by banks for regulatory and prudential needs are important for preventing risk from spreading during periods of financial stress, and should not weaken this “safety buffer.” “A reserve allocation that can enhance the safety of the banking system is an effective way to utilize the balance sheet,” she said.

But she also noted that some liquidity rules actually increase the level of reserves yet fail to improve system safety, because in a crisis banks often are unwilling to use those funds. Such arrangements represent inefficient use and should be considered for optimization.

In addition, regarding recent proposals to set a cap on the interest paid on reserves, Logan took a critical stance, saying it is similar to “central planning” and could suppress innovation, growth, and competition in the financial system.

(Editor-in-charge: Wang Zhiqiang HF013)

【Risk warning】According to regulations related to foreign exchange administration, buying and selling foreign exchange should be conducted at transaction venues designated by national authorities such as banks. For privately buying and selling foreign exchange, engaging in disguised foreign-exchange trading, conducting round-trip foreign-exchange trades, or engaging in illegal intermediary services for buying and selling foreign exchange in amounts that are relatively large, administrative penalties will be imposed by the foreign exchange administration authority according to law; if a crime is constituted, criminal liability will be pursued according to law.

Report