Understanding RBA’s move to “ample reserves”

Introduction

The Reserve Bank of Australia's (RBA) recent announcement of a transition towards an "ample reserves" system reflects a broader trend towards reforming central banking practices.

It follows last year’s appointment of Michelle Bullock as Governor and the recruitment of 30-year Bank of England capital markets/financial operations veteran, Andrew Hauser as Deputy Governor, as well as a restructure and bifurcation of the RBA’s governance platform into a Monetary Policy Board (responsible for monetary policy decisions and financial stability oversight) and a new Governance Board that will oversee everything else.

And it also follows the not insignificant issues (and losses) resulting from the RBA’s less than successful yield curve control (rate targeting) program which ran from March 2020 to November 2021, as well as the hundreds of billions in bond purchases undertaken as a COVID response between November 2020 and February 2022.

It needs to be seen in light of the Term Funding Facility (TFF) coming to an end in the next couple of months as the last three year/low-cost loans made in June 2021 mature.

Given these massive changes, I thought it worth considering the key reasons/implications/risks of the bank moving to an "ample reserves" system.

Historical context and motivations for change

Central banking has a long and often maligned history that’s been shaped by a myriad of economic, political, and technological factors.

Traditionally, central banks have employed corridor-based frameworks to implement monetary policy, targeting short-term interest rates through open market operations and reserve requirements.

However, the efficacy of these traditional approaches has come under scrutiny in light of their complexity and limited effectiveness during periods of crisis.

The COVID-19 pandemic, in particular, has highlighted the need for a more adaptive, resilient, equal access and less ‘blunt instrument’ approach to monetary policy implementation, and has prompted central banks to explore alternative frameworks that offer greater flexibility and simplicity.

And of course, it’s now time to run down some of the gargantuan central bank balance sheets, if at all possible.

Different Models

There are many approaches to monetary policy implementation which can exist as the dominant framework, or as one of a number of (favoured) tools in a central bank’s monetary policy arsenal.

Here are examples of some of the key policy frameworks.

Floor System

Example: The European Central Bank (ECB) has employed a floor system as part of its monetary policy framework. Through its Targeted Longer-Term Refinancing Operations (TLTROs) and asset purchase programs (what we call QE, see tool 3 below), the ECB provides ample liquidity to eurozone banks, setting a floor on short-term interest rates. This approach aims to support bank lending and economic activity while maintaining price stability within the euro area.

Inflation Targeting

Example: The Reserve Bank of New Zealand (RBNZ) was one of the pioneers of inflation targeting, adopting this framework in the early 1990s. Under inflation targeting, the RBNZ sets a specific target range for CPI (1% to 3%) over the medium term and adjusts its policy interest rate, the Official Cash Rate (OCR), to achieve a target mid-point of 2%. This approach is designed to provide flexibility, clarity, and transparency in relation to policy objectives, anchor inflation expectations, and guide market participants' behaviour.

Corridor System plus Quantitative Easing (QE)

Example: The U.S. Federal Reserve (the Fed) uses a corridor system to influence short-term interest rates. In this system, the Fed sets a target range for the federal funds rate, which is the rate at which banks lend reserves to each other overnight. The Fed implements its target rate by adjusting the interest rates it pays on excess reserves held by banks and by conducting open market operations to control the supply of reserves in the banking system. However, when traditional monetary policy measures (like adjusting interest rates) have become ineffective, the Fed like many other central banks purchases financial assets, typically government bonds and mortgage-backed securities from the open market, thereby injecting money into the financial system with the aim of lowering long-term interest rates, boosting lending and investment, and stimulating economic activity. The Fed has implemented several rounds of QE following the GFC and over three subsequent programs in 2010, 2012 and the COVID program in 2020.
Quantitative Tightening (QT) is the opposite and is achieved through the Fed ‘running off’ its balance sheet when it does not reinvest all of the funds it receives when purchased treasuries mature, like it’s doing now.

Interest rate smoothing

Example: The Bank of Japan (BOJ) has employed an interest rate smoothing approach as part of its monetary policy framework. Instead of adjusting interest rates abruptly in response to economic shocks, the BOJ gradually changes its policy rate target over time, aiming to provide stability to financial markets and avoid excessive volatility in short-term interest rates. This approach helps anchor inflation expectations and supports economic stability in Japan. However, the BOJ also uses QE, which it started in 2001, and up until recently it ran a yield curve control (YCC) program to ensure the 10-year JGB remained at a yield of 0% to 0.1%, however this restriction has now been removed.

Targeting the Exchange Rate

Example: The Swiss National Bank (SNB) targets the exchange rate as part of its monetary policy framework. The SNB intervenes in foreign exchange markets to influence the value of the Swiss franc (CHF) relative to other currencies, particularly the euro (EUR). By maintaining a target range for the EUR/CHF exchange rate, the SNB aims to support price stability and ensure the competitiveness of Swiss exports in global markets. This is used in conjunction with new issuance, repo transactions, and the purchase and sale of its own debt certificates (SNB Bills).

Finally, the People's Bank of China (PBOC), China's central bank, implements a multifaceted approach to monetary policy and utilises a combination of tools to achieve its policy objectives. In contrast to adhering strictly to a single framework like the corridor approach or “ample reserves” approach, the PBOC employs various measures to influence money market rates, manage liquidity, and support broader economic goals. These measures include adjusting key policy interest rates, conducting open market operations, setting reserve requirement ratios for commercial banks, implementing targeted lending programs, and intervening in the foreign exchange market. By employing this diverse toolkit, the PBOC aims to regulate credit creation, control inflation, support economic growth, and ensure financial stability within China's economy.

Recent shifts in thinking

More recently, several central banks around the world have adopted or considered adopting systems similar to the "ample reserves" framework. The European Central Bank (ECB), the Bank of England, and the Swedish Riksbank are among those that have announced plans to transition their operational frameworks.

One key difference between the "ample reserves" system and traditional approaches, such as those employed by the Federal Reserve (Fed), lies in how they manage liquidity in the banking system.

The Fed, which I often write about, has historically operated with a "corridor" system where it sets a target range for the federal funds rate and provides or withdraws liquidity as needed to keep the rate within that range.

In a corridor system, banks hold reserves either slightly above the minimum required level (excess reserves) or slightly below it (scarce reserves), and the Fed adjusts the supply of reserves to influence short-term interest rates.

But as we have seen in the U.S. this can lead to unproductive money creation and high repo/reverse repo account balances. In turn, it creates moral hazard for banks as they can choose to stop lending and instead achieve riskless return on excess reserves held in their Fed accounts.

However, under the "ample reserves" system, the central bank provides just enough reserves to the banking system to ensure smooth functioning without necessarily targeting a specific interest rate, and without over-creating unproductive reserves/money.

This approach aims to simplify the implementation of monetary policy by removing the need for precise control over the quantity of reserves and allowing the market to determine short-term interest rates within a broader range.

The key differences between the two systems lie in their operational frameworks and the degree of control exerted by the central bank over short-term interest rates. While traditional approaches provide more direct control over interest rates, “ample reserves” systems offer greater flexibility and simplicity in managing liquidity.

As central banks transition to new operational frameworks, ongoing monitoring and evaluation will be needed to assess their effectiveness in achieving policy objectives and maintaining financial stability.

Benefits and risks?

At its core, the "ample reserves" system represents a departure from the traditional corridor-based approach to monetary policy implementation. Instead of targeting a specific short-term interest rate, central banks aim to provide a sufficient level of reserves to meet the demand of banks, thereby ensuring smooth market functioning without the need for precise interest rate targeting. This approach offers several potential benefits, including:

Benefits:

Simplicity and flexibility: The "ample reserves" system offers a simpler and more flexible approach to managing liquidity compared to traditional frameworks. This could streamline monetary policy operations and enhance the RBA's ability to respond to changing economic conditions.
Reduced volatility: By providing sufficient reserves to the banking system, the "ample reserves" system aims to reduce volatility in short-term interest rates and money markets. This could contribute to more stable financial conditions and support economic growth.
Resilience: The system may be more resilient to shocks and disruptions in financial markets, as it does not rely on precise control over interest rates or the quantity of reserves. This could enhance the central bank's ability to maintain financial stability in challenging circumstances.

Risks:

Market distortions: Excessive liquidity provision could distort market dynamics and incentivise excessive risk-taking by market participants. This could lead to asset price bubbles or other imbalances in the financial system.
Communication challenges: Transitioning to a new monetary policy framework could pose communication challenges for central banks, particularly if market participants misunderstand or misinterpret central bank intentions.
Effectiveness of monetary policy: The effectiveness of monetary policy transmission mechanisms under the "ample reserves" system may differ from traditional approaches. Central banks may need to adapt policy tools and communication strategies to ensure monetary policy objectives are achieved.
Inflationary pressures: Excessive liquidity provision could potentially fuel inflationary pressures if demand for credit and economic activity outpaces the supply of goods and services. Central banks must monitor inflationary trends closely and take appropriate policy actions to maintain price stability.

Does is shift control to banks?

The transition to an "ample reserves" system does not necessarily shift control of the monetary system to banks instead of the central bank or government. Instead, it changes the operational framework through which the central bank manages liquidity in the banking system.

Under the "ample reserves" system, the central bank plays a central role in providing reserves to the banking system. However, instead of targeting a specific interest rate as in traditional approaches (such as the Fed’s corridor system), the central bank aims to ensure that there are enough reserves in the system to support the smooth functioning of financial markets.

In this system, banks have more autonomy in determining the level of reserves they hold, as they can borrow or lend reserves in the interbank market based on their liquidity needs. The central bank, meanwhile, provides reserves through open market operations (e.g., repo auctions) to meet the overall demand for liquidity in the system.

The goal of the "ample reserves" system is to simplify the implementation of monetary policy by allowing the central bank to focus on providing sufficient liquidity to support financial stability and monetary transmission, rather than fine-tuning interest rates.

That said, the central bank still maintains control over the overall supply of reserves and can adjust its operations as needed to achieve its policy objectives.

While the "ample reserves" system might give banks more flexibility in managing their reserves, it does not relinquish control of the monetary system to banks.

The central bank remains responsible for ensuring the stability and effectiveness of the monetary system through its operational decisions and policy actions.

Implications for Central Banking and policy implementation

The transition to an "ample reserves" system has far-reaching implications for central banking practices and policy implementation.

Transitioning central banks would need to adapt their operational frameworks, policy tools, and communication strategies. Key considerations include:

Operational adjustments: Central banks may need to recalibrate their operational procedures and infrastructure to support the implementation of the "ample reserves" system effectively.
Policy tools and communication: Central banks must refine their policy tools and communication strategies to navigate the complexities of the new framework and to ensure their mandates, particularly price stability, are achieved.
Monitoring and evaluation: Ongoing monitoring and evaluation will be essential to identify emerging challenges or areas for improvement.

In light of the RBA’s proposal to transition to an “ample reserves” system with full allotment auctions for Open Market Operations (OMO) repos, the central bank has released a consultation paper outlining key considerations and is seeking feedback from stakeholders.

If you’re interested in making a submission, the consultation paper can be found here.

Final thoughts

The proposed transition to an "ample reserves" system in Australia represents a significant evolution in central banking practice.

Under the new system, the RBA will provide a sufficient level of reserves to meet the demand of banks and ensure the smooth functioning of financial markets, instead of directly targeting an interest rate.

This approach will have profound implications for monetary policy implementation and financial market functioning and while it may offer potential benefits such as simplicity and flexibility, it also entails risks and challenges that will need to be carefully managed.

In the interim, and assuming the bank transitions, and as always subject to the architecture post-consultation, the RBA will need to strike a delicate balance between innovation, risk management and delivering on its mandate.

By embracing proactive measures, refining policy frameworks, and fostering open dialogue with market participants, the RBA has an opportunity to lay the groundwork for a more resilient and adaptable monetary policy framework.

See you in the market,

Mike

Michael GanonApril 16, 2024