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The Federal Reserve’s balance sheet and overnight interest rates: Empirical modeling of exit strategies

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  • Marquez, Jaime
  • Morse, Ari
  • Schlusche, Bernd

Abstract

This paper provides a comprehensive study of the interplay between the Federal Reserve’s balance sheet and overnight interest rates. We model both the supply of and the demand for excess reserves. Treating outright securities holdings of the Federal Reserve as a policy tool, we estimate the effects of unconventional monetary policy on overnight funding rates. Further, we offer the first empirical assessment of the FOMC’s principles of the exit strategy. Assuming a path for removing monetary policy accommodation that is consistent with the FOMC’s exit principles, we project that the federal funds rate increases to 70 basis points by 2016, settling in a corridor bracketed by the discount rate and the interest rate on excess reserves, as excess reserves of depository institutions decline to near zero.

Suggested Citation

  • Marquez, Jaime & Morse, Ari & Schlusche, Bernd, 2013. "The Federal Reserve’s balance sheet and overnight interest rates: Empirical modeling of exit strategies," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5300-5315.
    • Handle: RePEc:eee:jbfina:v:37:y:2013:i:12:p:5300-5315
    DOI: 10.1016/j.jbankfin.2013.01.015
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    References listed on IDEAS

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    1. Judson, Ruth A. & Klee, Elizabeth, 2010. "Whither the liquidity effect: The impact of Federal Reserve open market operations in recent years," Journal of Macroeconomics, Elsevier, vol. 32(3), pages 713-731, September.
    2. Friedman, Benjamin M. & Kuttner, Kenneth N., 2010. "Implementation of Monetary Policy: How Do Central Banks Set Interest Rates?," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 24, pages 1345-1438, Elsevier.
    3. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
    4. Carpenter, Seth & Demiralp, Selva, 2006. "The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(4), pages 901-920, June.
    5. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
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    7. Clouse James & Henderson Dale & Orphanides Athanasios & Small David H. & Tinsley P.A., 2003. "Monetary Policy When the Nominal Short-Term Interest Rate is Zero," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-65, September.
    8. Bech, Morten L. & Klee, Elizabeth, 2011. "The mechanics of a graceful exit: Interest on reserves and segmentation in the federal funds market," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 415-431.
    9. Alexander H. Boote & Seth B. Carpenter & Jane E. Ihrig & Elizabeth C. Klee & Daniel W. Quinn, 2012. "The Federal Reserve's balance sheet: a primer and projections," Finance and Economics Discussion Series 2012-56, Board of Governors of the Federal Reserve System (U.S.).
    10. Kopchak, Seth J., 2011. "The liquidity effect for open market operations," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3292-3299.
    11. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
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    13. Ben S. Bernanke & Vincent R. Reinhart, 2004. "Conducting Monetary Policy at Very Low Short-Term Interest Rates," American Economic Review, American Economic Association, vol. 94(2), pages 85-90, May.
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    Cited by:

    1. Green, Christopher & Bai, Ye & Murinde, Victor & Ngoka, Kethi & Maana, Isaya & Tiriongo, Samuel, 2016. "Overnight interbank markets and the determination of the interbank rate: A selective survey," International Review of Financial Analysis, Elsevier, vol. 44(C), pages 149-161.
    2. Falk Bräuning, 2017. "The liquidity effect of the Federal Reserve’s balance sheet reduction on short-term interest rates," Current Policy Perspectives 18-1, Federal Reserve Bank of Boston.
    3. Ansgar Belke, 2014. "Exit Strategies and Their Impact on the Euro Area - A Model Based View," Ruhr Economic Papers 0467, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
    4. repec:zbw:rwirep:0467 is not listed on IDEAS
    5. Ansgar Belke, 2014. "Exit Strategies and Their Impact on the Euro Area – A Model Based View," ROME Working Papers 201401, ROME Network.
    6. Fukunaga, Ichiro & Kato, Naoya, 2016. "Japanese repo and call markets before, during, and emerging from the financial crisis," Journal of the Japanese and International Economies, Elsevier, vol. 39(C), pages 17-34.

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    More about this item

    Keywords

    Reserve balances; Federal funds rate; Balance sheet; Exit strategy; FIML;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E65 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Studies of Particular Policy Episodes
    • G01 - Financial Economics - - General - - - Financial Crises
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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