Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve

Joseph E. Gagnon (PIIE) and Brian Sack (D. E. Shaw Group)
Policy Brief
January 2014

The amount of assets held by the Federal Reserve has dramatically increased since 2009. It recently crossed $4 trillion and will likely peak at about $4.5 trillion. This increase is the result of the Fed's large-scale asset purchase programs, which were intended to support economic growth. However, these purchases have created unprecedented amounts of liquidity in the financial system. Gagnon and Sack doubt that the Fed can smoothly conduct monetary policy along the lines of the previous operating framework in this environment of high liquidity. Instead of reducing bank reserves to achieve a target level for the federal funds rate, they propose a new operating framework that would allow the Fed to maintain an elevated balance sheet along with abundant liquidity in the financial system. They argue that the Fed should set the rate at which it will offer overnight reverse repurchase agreements as its policy instrument, with the interest rate paid on bank reserves set at the same level. The federal funds rate would become just one of the various overnight interest rates determined by the market in the normal transmission of monetary policy.

Data disclosure: Publically available data underlying this analysis are available at the Federal Reserve website. Proprietary data are available from Blue Chip, Bloomberg, and Credit Suisse.