Monetary Policy without Reserve Requirements: Case Studies and Options for the United States
Sellon, Gordon H., Jr., Weiner, Stuart E., Economic Review (Kansas City, MO)
Over the past decade, the level of required reserve balances held by depository institutions in the United States has declined dramatically. Indeed, most depository institutions can now meet reserve requirements by holding vault cash rather than by maintaining balances at the Federal Reserve. Part of this decrease resulted from the Federal Reserve's decision to reduce reserve requirements in 1990 and 1992 to reduce bank costs and stimulate lending. More recently, depository institutions have been able to cut required balances even further by sweeping funds from reservable to nonreservable accounts, circumventing reserve requirement regulations.
The decline in reserve balances has fueled a debate over the role of reserve requirements. On the one hand, proponents of reserve requirements argue that low reserve balances may complicate monetary policy operations and increase short-term interest rate volatility. Thus, they advocate the Federal Reserve take actions to stop the continuing erosion of reserve balances. On the other hand, critics of reserve requirements argue that lower reserve requirements remove a distortionary tax on depository institutions and need not complicate monetary policy operations.
In a previous article, we provided an analytical framework for thinking about these issues (Sellon and Weiner). That article suggested that monetary policy can be conducted in a world of low or zero reserve requirements as long as there continues to be a demand for central bank balances. Such demand is likely to arise from the need of financial institutions to hold central bank balances for settlement purposes and to transact business with the government. The demand for settlement balances is likely to be behaviorally different from the demand for reserves, however, leading to two potential problems for monetary policy operations. First, because the demand for central bank balances arises from payments needs rather than from a mandated linkage to deposit liabilities, the structure of the payments system becomes an important factor in the design and implementation of monetary policy operating procedures. Consequently, changes in the payments system may affect the demand for settlement balances and complicate monetary policy. Second, short-term interest rate volatility could increase as reserve requirements decline if the demand for central bank balances becomes more difficult to forecast or if the interest sensitivity of this demand is reduced. Increased interest rate volatility would be of concern to the extent it had negative effects on economic activity.
While these potential problems are valid in theory, it is not clear how important they are in practice. To judge their practical importance, in this article we examine how three countries--Canada, the United Kingdom, and New Zealand--conduct monetary policy without using reserve requirements. The experience of these three countries provides insight into the linkages between the payments system and monetary policy and into the connection between reserve requirements and interest rate volatility. This insight is particularly helpful in understanding the implications of a further reduction of reserve balances in the United States. The analysis suggests that reserve requirements are not essential for the conduct of U.S. monetary policy provided the Federal Reserve is sufficiently flexible in modifying existing mechanisms for providing liquidity to the banking system.
This article has four main sections. The first section reviews the implications of declining reserve requirements for monetary policy. The second section describes how the central banks in Canada, the United Kingdom, and New Zealand conduct monetary policy without reserve requirements and examines the relationship between the payments system and monetary policy procedures. The third section uses the experience of these three countries to analyze the connection between reserve requirements and interest rate volatility. …