My objective is to provide options if

the Fed were to decide to reduce its

balance sheet. How could it do it?

>> The Fed's not going to send the SWAT

team, the military to the banks to

people's houses to get all the cash.

It's not not going to happen at all. So,

the only real channel to reduce it is

reducing reserves.

>> I also have the view that the Fed should

develop these options in case they're

needed, in case it becomes a break the

glass situation.

>> Today's episode is brought to you by the

Fundrise Income Fund. You'll hear more

about the income fund later in the show,

but for now, let's get into today's

interview. The new Fed Chair, Kevin

Walsh, has made it no secret that he

prefers a smaller Federal Reserve

balance sheet, perhaps a much, much

smaller Federal Reserve balance sheet.

The consequences of this range from the

mundane to the profound. But what is

without question is that in order to

reduce the Fed's balance sheet, there

needs to be additional tools. I was able

to interview someone who's the most in

demand expert on this topic. Professor

Daryl Duffy just wrote a paper proposing

four techniques the Fed can use in order

to reduce the demand of reserves,

thereby allowing it to reduce its

assets. If the Fed were to try and

reduce its balance sheet drastically

without addressing the very high demand

for reserve balances from the banking

system, then there could be a flare up

in funding markets such as the one we

experienced in September 2019 or during

the fall of 2025. I think the Federal

Reserve has a very responsible

institution that's very unlikely to

happen. So if in several years or

perhaps even a decade the Federal

Reserve's balance sheet is much much

smaller, I think it is highly likely

that the Fed will use one or some or

perhaps all of the techniques proposed

in this groundbreaking paper. I have to

say that this interview with Daryl Duffy

is very complex, much more so than our

first interview. And when preparing and

conducting this interview, there were

many times when I was very confused. So

if you feel like that, please do not be

intimidated. I bet there will be

economic PhDs watching this who are

going to watch it twice just so they

fully understand this. And we will of

course include that paper called the

payment system puts a floor on the Fed's

balance sheet as well as another paper

by Daryl Duffy. Let's get into it. We

have a very important conversation

today. I'm joined once again by Daryl

Duffy, distinguished professor of

management and professor of finance at

the Stanford Graduate School of Business

as well as the department of economics.

Professor, welcome to Monetary Matters.

Good to see you again.

>> Great to be back with you, Jack.

>> I today want to talk about a very

specific topic and I'm going to set the

stage a little bit. So, we have a new

chair of the Federal Reserve, Kevin

Worsh. He has stated a desire to reduce

the Fed's balance sheet, something that

has been going on since 2022. The issue

is that that is a very difficult thing

to do. And basically the Fed's balance

sheet bottomed uh last year at let's see

where we are about $6.5 trillion which

sounds you know is a is a huge number

and since then it's been very very

modestly growing and the question is how

is the Federal Reserve going to continue

to shrink its balance sheet and you are

on the cutting edge of making some

suggestions about how the Fed is going

to do that. You have four ideas. Before

we get into those four ideas, could you

just continue to set the stage for for

me and for our audience? Why is it that

the Fed has had such difficulty getting

below the so-called LR or the lowest

comfortable level of reserves? What are

we talking about here?

>> Terrific. You framed it ex uh with

excellence, Jack, as usual. So, in the

popular discussion of the Fed's balance

sheet size, most people are focusing on

the assets. How many how much of this

6.5 trillion dollars of assets does the

Fed really need to hold? And couldn't it

get rid of some of these assets without

blowing up the economy? And actually,

that's not the right way to look at it.

uh we should move over to the other side

of the balance sheet where the

liabilities are

because the assets by definition have to

be at least as large as the liabilities

and it's really hard to squash down the

Fed's liabilities as it turns out. So

even if the Fed didn't want to own any

of those assets, it has to own enough to

support the liabilities. And some of

them you just can't get rid of like

paper currency. What do you do? you go

out and ask people to give back their

paper currency. I don't think that's

going to work. And there's $2.5 trillion

dollar of paper currency. So that kind

of sets a baseline right there. And as

we go through this discussion, I'm just

basically going to walk through how one

would reduce the need for the Fed's

liabilities. You can't simply sell

assets today and avoid problems because

all of the liabilities on the Fed's

balance sheet are serving very important

roles. So if I if I can just let me walk

through briefly what those are, at least

the big ones, and then we'll come back

to where there is scope over time to

reduce the need for one of those

liabilities, which is reserve balances

or the deposits of commercial banks held

at the Fed. So let's set the stage. If

there's 6.5 trillion of assets, there's

got to be 6.5 trillion of liabilities.

I've already said you can't do much with

2.5 trillion of those, which is paper

money.

There's about three trillion of

reserves. These are commercial bank

deposits at the Fed. We're going to come

back to that in detail because that's

where there's some scope. There's about

a trillion or so of deposits held at the

Fed by the federal government. That's

called the Treasury General Account. So

that's when the Treasury Department

collects money or pays money, it pays it

out of that account at the Fed. And

there is a little bit of scope to reduce

that trillion and the Treasury Boring

Advisory Committee has been floating

ideas about how that could be done, but

it's not the main show because, you

know, maybe you could cut it down by

half. Well, that's 500 billion. That's,

you know, not what I think Chair Wars is

talking about. He's talking about the

big game which is the reserve balances.

Uh at least that's what I'm going to

infer because that's three trillion a

lot more scope for reduction. Now there

are there's a smattering of other things

like money held at the Fed by foreign

central banks and a few other odds and

ends. I'm not going to get into those.

>> The big three are the Treasury General

account, cash in circulation, and the

reserve balances. The Treasury General

account not big enough. The cash in

circulation, you know, the Fed is is

just not going to happen. The Fed's not

going to send the SWAT team, the

military to to to the banks to people's

houses to get all the cash. It's not not

going to happen at all. So, the only

real channel to reduce it is reducing

reserves.

>> You got it. So, starting at And by the

way, reserves are actually going up at

the moment or have been over the last 6

months because the Fed discovered late

last fall that it had gotten reserves

down as low as they could get them and

it had to start growing them again at

around 40 billion a month. By purchasing

treasury bills, the Fed can expand the

supply of reserves. Again, those are

deposits of commercial banks at the Fed

and the banks use them for a number of

purposes. Most importantly, just to make

their daily payments to each other,

which are huge. Okay, so you got around

three trillion of balances. They're

growing. How could you reduce the need

that commercial banks have to hold those

balances at the Fed?

Well, I I already mentioned you need

them the banks need them to make

payments.

Just one of the Fed's payment systems,

the largest one called Fedwire, there's

$4.5 trillion

of of payments every day going through

Fedwire. And this these are payments by

banks to each other to meet the needs of

their customers. uh you know to makes t

make tax payments for purchases of bonds

for margining of derivatives for many

many other uh purposes even small retail

payments uh ultimately are netted down

and paid with reserve balances. So this

the payment system is exceptionally

demanding of reserve balances in the

United States. How could you reduce the

need that banks have to make those

payments? And sorry D professor before

we get into that just if the Fed was to

go willy-nilly say I don't need the

professor Duffy's four recommendations I

don't need any other recommendations and

they just were to be a net seller of all

their assets. What would happen? Talk to

us what happened in 2019 and what

happened in the last year in terms of

the the spreads and stuff.

>> So what would happen if the Fed said uh

you know never mind the liabilities I'm

just going to reduce the assets. they

start selling assets. Now what happens

when they sell assets is that the

purchases by the private sector of those

assets are paid with reserve balances.

Those are and that extinguishes those

reserve balances. So the three trillion

will go down for every hundred billion

of assets that are sold 100 billion of

reserve balances are extinguished. And

what would happen if the banks had a

hundred billion or 200 billion less of

reserve balances? Then they would, you

know, they would look each day and say,

"Well, gosh, today looks like I'm going

to need a lot of balances to meet my

payment needs. I am not allowed or I

feel that I should not go below zero in

my account at the Fed. So, I'm going to

if anybody calls me and wants to do uh

wants to me to lend money in them to

them in the repo market, I'm gonna have

to charge them a very high interest rate

to make it worthwhile." And in September

2019, that's exactly what happened.

Jaime Diamond, the CEO of JP Morgan,

famously

was asked in the earnings call

immediately after that episode, you

know, I'm paraphrasing, Mr. Diamond,

uh, the repo rates were going up

hundreds of basis points on September

the 17th.

Why didn't you use some of your reserve

balances, lend them into the repo market

and get those exceptionally high

interest rates that would have quelled

the disruption in money markets if you

were to have used your balances and loan

them to the market. And Diamond said

there's a red line. We cannot go below

zero because of liquidity regulations.

We are expected to be self-sufficient in

meeting our liquidity requirements. So

if we have to go to the Fed because we

run out of reserves in the middle of the

day, that's not going to look good. Here

I'm paraphrasing still. He said, and he

he named specific regulations. One's

called Reg Y and one's called

resolution, liquidity, and planning

requirements. And those those Fed

regulations say that the globally

systemically important banks like JP

Morgan need to be self-sufficient in

meeting their own liquidity needs. Now

they don't the regs don't say and

therefore you can't go to the Fed and

get more reserves but the largest banks

have interpreted it that way and they

feel that it would not look good if they

were to go to the Fed in the middle of

the day and say we ran out of reserves

can we get some more? Uh so they so they

don't and as Jamie Diamond said they

didn't lend money into the repo market

and interest rates in the repo market

skyrocketed to about over 300 300 basis

points above the interest rate that the

Fed pays to banks and intraday in the

interdeer market around a thousand basis

points above. The Fed recognized that it

had reduced

reserve balances below where they needed

to be for banks to meet their needs and

immediately reverse course and added

reserves to the system and that quelled

the problem.

>> So if the Fed sells too many assets or

lets too many assets go down and

reserves go down, the it loses control

of interest rates which is literally its

job. So it doesn't want to do that. We

saw that in extreme amounts as you said

in September 2019. I mean, wow. You said

a thousand basis points

>> in the inter dealer market. That day,

rates went to a thousand basis points

above normal, above the deposit rate

that the Fed provides, which is crazy.

Crazy.

>> 10 10% in what's supposed to be the

safest market in the world. Totally

crazy. And then you saw uh we can put up

some charts from later in the fall of

last year, a more muted but similar

there was some stress in that market.

And as such, the Fed has done liquidity

injections essentially by buying a

certain amount of Treasury bills in the

market every month. Right.

>> Yeah. Exactly. Right. After the blow up

in September 2019, the Fed got much more

conservative about letting this happen

again. And when there were inklings last

fall that there might not be enough

reserve balances and interest rates and

the repo market were creeping above

where the Fed was targeting them,

especially at the end of October, the

Fed realized, okay, this is it. We

better add more balances to the system

and we can do that by buying Treasury

bills.

>> Yes. And the level of reserves went up a

huge amount after in in 2008. Basically

the Fed used to control interest rates

by controlling the level of reserves and

now they control interest rates by just

setting the the interest rate and paying

interest on reserves. So the lever

through which they control interest

rates is no longer the the level of

reserves. But as a consequence they

can't reduce the amount of reserves a

ton or they they literally lose control.

Okay, perfect summary. And I would just

add it's asymmetric because if the Fed

loads up too much reserves, it doesn't

really cause a problem for monetary

policy implementation because as you

said, market interest rates are guided

by the interest rate that the Fed pays

on reserve balances, not by the quantity

of money. However, if you don't have

enough reserve balances in the system,

that can get messed up and suddenly you

can get these, you know, very volatile

periods when uh core interest rates like

the repo market rates uh go go way above

where they're supposed to be.

>> Right. So, prior to the fall of 2008,

the Fed was under a so-called floor

system and now we are in a so-called

corridor system. So, people can can look

that up later. All right, professor.

What are the four recommendations that

you have? And perhaps should we start

with the simplest and least extreme sort

of least controversial ones and then

we'll move on.

>> Well, they're all kind of controversial

actually,

>> but some of them are, as you say, are

less extreme and easier to do. And I and

I wrote I wrote a paper for the

Brookings Institution

uh earlier this year in the Brookings

papers uh for econom on economic

activity and uh I gave you the floor on

the Fed's balance sheet.

>> Yeah, that's it. Okay, good.

>> I gave four idea, four options in kind

of increasing order of difficulty and

also impact. And the most

straightforward one and even that this

one is not a you know is not obvious and

is controversial within the Fed is

temporary open market operations. So uh

you know rather than uh setting the

course of reserve balances uh on a kind

of autopilot you know adding 40 billion

a month or keeping it flat and then

waiting to see what happens. the Fed

could on a day-to-day basis offset

uh sudden changes in reserve balances by

uh doing what are called temporary open

market operations. So when reserve

balances pop down due to something else

going on like the the Treasury

Department needs a lot of uh deposits in

the Treasury General account and they

come out of reserves suddenly the

there's not enough reserves. The Fed

could do a temporary open market

operation, which means they could uh

conduct their own repos to create more

cash to create more reserves and that

would fill in that those those missing

reserves. Think of the think of this as

you're you're you're running on a along

a smooth highway and there are potholes

and the potholes are the the level of

the highway is the quantity of reserve

balances in the system and occasionally

you're going to hit one of these

potholes and so you want to fill it in

with temporary open market operations

and that's that's the easy step and that

could reduce the average path of reserve

balances by perhaps a 100red billion or

200 billion. Not a huge amount, but um e

easy easy easy in terms of policy. The

FOMC could simply direct the market

operations group at the New York Fed to

keep an eye on reserve balances and

whenever they pop down, fill them back

up again the next day. And and if you

want to save on average, it goes the

other way. Whenever they pop up

unexpectedly, that means you don't need

as much. You can take take some out of

the system. And and the Fed is familiar

with these kinds of operations. it would

be relatively straightforward to do

them, but it's not as straightforward as

a policy matter because some policy

makers at the Fed believe that they

shouldn't be active in the markets on a

daily basis filling in these holes and

take and chipping off these bumps. They

should just set set a kind of steady

course for their operations and not

touch it until you know something big

happens. And under what circumstances

would the Fed encounter these potholes

and can you just remind us of the

figures of how much hundreds of billions

this would reduce reserve demand by?

>> Yeah. So here here are a couple of

examples. Uh one is it's tax season.

I'll give you one example. And suddenly

taxpayers are going to pay their tax

bills and that includes corporates and

individuals. And this happens a lot in

you know in the spring particularly in

April. Well, if there's an influx of

money into the Treasury general account

where people are paying taxes in, it has

to come out of reserve balances because

that's the only way ultimately that the

Treasury gets paid by banks and people

pay their taxes through the banks.

So when tax season starts gushing money

into the Treasury general account, it's

gushing money out of reserve balances

and the the Fed could say, "Oh, we

didn't really, you know, we thought we

had about the right amount, so let's

replace those missing balances with new

balances that we can create with

temporary open market operations." So

that's one example. Another example is

that at the end of every quarter,

foreign banks that have accounts at the

Fed are monitored for capital adequacy.

And uh suddenly they want to reduce

their balance sheet so they look good on

capital adequacy. And the easiest way to

make their balance sheets look smaller

for one day

is to get rid of a bunch of reserves.

And that that's happened to the extent

to the tune of 200 to500 billion dollars

over the last few years.

>> Sorry. Do you mean get rid of a bunch of

reserves or get rid of a bunch of assets

and increase reserves?

>> Well, their reserves are assets.

>> Okay. Okay. Okay.

>> Their reserves are their deposits at the

at the Fed. That's on the asset side of

their li of their balance sheet. And so

they have to have capital against all

their assets. And so an easy way to get

rid of some of their assets is to ditch

a bunch of reserves. And they do that

systematically for one day at the end of

each quarter. Now you might ask, well,

why do foreign regulators allow this?

And that's another conversation because

I mean obviously the other 90 days in

the quarter, they're not meeting their

capital requirements.

Uh but they're only monitored on the

quarter end. So that's all the only

thing they care about.

>> Yes, this I we talked about at length in

our first conversation. People can look

that up on January 2025. Professor, I'm

going to share there are two charts in

this section in your paper which we will

attach uh this chart and then the

subsequent chart. Can you explain what

we're looking at here and and the

relevance?

>> I think we should uh probably do this at

a very high level because first of all

as I said this is not that

consequential. It can save you a 100red

billion or 200 billion in the average

path of reserve balances. And so it's

not like really big game. Although it is

it is high on the list in terms of ease.

The other ones, wait till you get to the

other ones are going to be more and more

difficult. But anyway, uh briefly going

through it, the top panel, there's three

panels on this page. The top panel shows

the cumulative amount of these temporary

open market operations that would be

used to offset the bumps in the path of

reserve balances held in the system. And

I'm colorb blind, but I think one of the

colors is green. The the one that and

that's the TGA. So that that's the

offset. Those are the temporary open

market operations that would offset

fluctuations in the Treasury General

account. The red bars at the end of each

quarter, those are the ones that offset

the quarter end balances that are lost

when foreign banks reduce their

reserves. And the the blue line is the

one that offsets changes in reserve

balances caused by foreign central banks

that store money at the Fed and in in

what's called a FEMA repo uh operation,

which is technical. And I I think that I

think that's probably enough from this

page.

And then uh these are bar charts showing

on the left the largest reductions in

reserve balances with these temporary

open market operations and then without

them. And if you have really good eyes,

you can probably see that the ones with

the reserve balances, you know, they're

not so big on the ta in the big tail on

the right. the very large uh reductions

in reserve balances are much smaller

when you when you uh conduct temporary

open market operations. And the right

the right hand bar chart is a histogram

of the sizes of these temporary open

market operations. So you can see they

range from increasing reserve balances

by about $300 billion on a given day to

reducing it by about 300 billion on a

given day

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This is a paid advertisement. Thanks for

listening. Let's get back to today's

interview. Yes. and you describe them

as, oh, we're going to start with this

because these are the least

consequential and it's not big. It's

quote unquote only a few hundred

billion, but even for the Fed, a few

hundred billion is a lot. All right,

that's number one. What's the second

one?

>> Second one is uh the liquidity

regulations that Jamie Diamond spoke

about in that earnings call. So he

mentioned a couple uh one is called Reg

Y the other is called RLAP which state

as principle as a principle that the the

globally systemically important banks

should have enough liquidity to meet

their own needs without going to the

Fed. What does that mean? It means

they're reluctant to go to the discount

window to go to the Fed for repos to get

more reserves and they're also reluctant

to overdraft their reserve balance

account at the Fed. They have this

deposit account. Think of it as a

checking account. They're in they're

allowed to overdraft, but they don't

want to because it would look like they

didn't have enough liquidity of their

own. Uh so these liquidity regulations

could be

the Fed could emphasize in

communications to the largest banks, hey

look, yeah, we want you to be

self-sufficient, but on the other hand,

we don't if you need more reserves,

please come and see us. We have all

these facilities that are available. We

don't want you to go short and we don't

want to mess up our monetary policy

implementation by having rates skyrocket

just because

you're reluctant to come to the discount

window or use standing repo operations

or overdraft your deposit account at the

Fed. Just go ahead and use those when

you need them. Now it sounds a little

bit contradictory because on the one

hand we the Fed's saying you have to be

self-sufficient which implies don't come

to the Fed and the other hand you're

getting they're getting the message do

come to the Fed.

Uh and you know if you ask uh in my view

if you ask the leadership of the Fed

would you want these banks to come to

the Fed when they need more balances

they would all say absolutely that's

what those facilities are for. But if

you ask us, let's say a supervisor down

in the middle ranks of the supervisory

staff at the Fed,

um if they are ever concerned when they

see a bank go to the discount window to

get more balances, they might say,

"Yeah, well, I mean, of course we're

concerned."

Uh we're monitoring that situation very

carefully, and these banks are supposed

to be self-sufficient. There's a

regulation about that.

So, you know, it if you're the manager

at the bank that's responsible for uh

ensuring there's enough liquidity in the

middle of each day, you're probably

don't want to get uh a nasty memo from

your regulatory supervisor saying, "What

happened today? Why why did you have to

go to the discount window? That doesn't

look very good to us." So, it's kind of

like if you know there's a consumer who

had and they have a say a $12,000 credit

limit officially on paper from a bank,

but then anytime they spend more than

$300, they get these annoying calls from

the bank and they say, "What are you

doing? What are you What's going on?"

>> You know, I've never had one of those.

[laughter] So, so on paper they they say

we want you to use these liquidity tools

where you can borrow in times of stress

but they are kind of haunted by the

ghost of this regulation from after 2008

which I'm not saying is a bad thing of

they they need to hold a absolutely

massive amount of reserves and the

people who are supervising the banks at

the Fed and perhaps the FDI too whenever

they see the the banks use these tools

that they're supposed to be using in

their times of stress they get nervous.

>> That's a good summary, Jack.

>> Okay.

>> And you know, even if uh the supervisors

would just hold fire and say, "Okay,

well, I understand these things happen.

I'm not going to say anything." What

really matters is the perception at the

banks. If they perceive that, they might

get a black mark or a memo might be sent

to their boss saying, "Uh, what went

wrong?" If they have that perception,

that's enough for them to demand a lot

of reserves at the start of each day so

they don't go near zero.

>> So, how do we solve this stigma issue

and where where the Fed's standing repo

facility or in the discount window,

these tools to provide liquidity under

times of stress has barely been touched

even when the market repo rates blow

past the administered rate. And you

you've pointed out that there are other

central banks around the world such as

the Bank of England that have

transitioned to a demand driven system

without the stigma. How do we remove

this stigma? It sounds like a very hard

thing to do because the issue is

something that's intangible. It's kind

of like how how do you if you're a

marketing person, how do you change this

perception of a brand in a consumer's

head? Like it's it's not something

physical you can change. It's it's in

people's heads. There's two approaches

and one is to force the issue by

reducing the quantity of reserve

balances where the banks don't have a

choice. They have to go to the Fed

because there's no other way to meet

their required you know payment needs

and maintain their customer

relationships and you know do run their

businesses. So the the problem with that

forcing it by that approach is that

interest rates will get very volatile on

days when banks are running short

because they're not sure it's okay and

they're not, you know, they're going to

hold back. They're going to and they're

going to charge higher interest rates to

their counterparties and rates will get

quite volatile and banks will eventually

say, "Wow, these rates are exceptionally

high. I'm going to take advantage of

these. I need to borrow the money

anyway." rates will get volatile. people

will get used to that and then over time

the the those managing liquidity at the

largest banks will say hey you know what

it's been okay I mean there's not that

much stigma other banks are doing it we

can do it too and nobody seems to be

getting in trouble

uh so it's new the new business as usual

and that's what the bank of England was

able to do they have actually quite

volatile repo rates and they're okay

with that and the banks in the UK system

are okay with that there's sort of an

understanding that if you need the money

you you go to the bank of England but in

the meantime rates might be volatile so

it's a different regime if the US

financial system could adapt to that

it's called demand-driven regime then

rates would be more volatile but the

demand for reserve balances would also

go down the Fed could have a smaller

balance sheet so that's approach one

approach two is communication the Fed

could communicate very clearly and often

to the banks and to their own

supervisory staff. These facilities are

there to be used. We want

all the banks to feel free that they can

use these for their legitimate liquidity

needs. So, you know, we're open for

business. That that communication

strategy could also be successful. Of

course, the Fed has to get comfortable

with the idea that if these facilities

do get used a lot, then technically

these banks are not self-sufficient for

liquidity. they're violating some of the

principles of these regulations. I guess

there's a third approach which is change

the regulations

uh so that the you know the banks are

not required to be self-sufficient at

all times. There are exceptions.

>> Okay. And I believe this is the only

section in your paper that does not have

a chart. And that is indicative to me

that this is the most as I said before

intangible thing. It's hard to measure.

It's either they press a button saying

your reserves have to go down or it's

via communication, which is a very soft

tool that at least with regards to the

press, incoming Fed Chair Kevin Wars

does not seem to love that that tool. So

I I'm not going to I'm not calling this

a little wishy-washy, but would you

would you agree with me that it's a a

little harder to implement? Maybe

>> it's hard to model for sure to quantif

quantify. Uh the reason it's hard to

quantify is

>> as I said, it's about perceptions. It's

about perceptions at the Fed. Do we

really want the banks to use these

facilities in a way that demonstrates

that they're not self-sufficient? And if

so, can we communicate that? And then

there's perceptions at the globally

systemically important banks, you know,

are is it really okay uh uh kind of

reminds me of the movie Jaws. Is it okay

to go into the water or am I going to

get bitten by a shark? Uh if everybody's

else is in the water, I'm probably going

to go in, too. And as long as there's no

shark bites, I'll probably stay in the

water. So that's basically a perceptions

thing, right? And it's an equilibrium.

Uh there's an equilibrium to it because

if everybody else is doing it, I'm going

to be willing to do it as a bank. But if

nobody else is doing it, I don't want to

stick out like a sore thumb and be

drawing on the Fed's liquidity and

standing out like um you know, maybe I'm

a weaker bank.

>> Okay. So door number one is temporary uh

temporary market operations from the

Fed. Door number two, suggestion number

two is liquidity regulations.

What is tool number three that you

suggest for reducing reserve demand as a

way for the Fed to reduce its balance

sheet?

>> So the third uh approach in in my paper

is what's called the liquidity savings

mechanism which sounds like plumbing and

it is plumbing. So most, in fact, all

large developed market central banks

other than the Fed have a way to

conserve

on the amount of reserves that a bank

needs to make its payments every day. So

let's do a little role play. You're you

owe me uh10 billion today. I mean,

you're going to pay me$10 billion in

cash. It's going to it's going to come

to me two different ways. One is you're

just going to take 10 billion out of

your current stash of reserves and send

it to me. And by the way, it gets sent

through a payment system called Fedwire,

which is the world's largest payment

system. And the way you send it to me is

just send a message saying, "Take 10

billion out of Jack's account and put it

into Daryl's account at the Fed."

>> I don't like that. I like the other way.

>> Yeah. Okay. Well, sorry. You're going to

get it's that's going to come up

shortly.

>> Okay.

>> Okay. Now, it turns out uh that

unknown to you, there's a $12 billion

payment coming from JP Morgan to you.

>> Sounds good.

>> But you're not sure when it's going to

get there, but you're kind of hoping

maybe it'll get there in time. Uh that

you could use that money to pay the 10

billion to me. So rather than take the

10 billion out of your current stash,

you could send a message to a piece of

software at the Fed if it builds it, a

software called a liquidity savings

mechanism. And this the software says

uh Jack's message indicates he will be

paying Daryl 10 billion

in the next round, which could be 10:00

this morning.

And now the LSM, the liquidity savings

mechanism has that message in place.

Then it get gets a message from the

payments manager at JP Morgan saying we

are going to be paying Jack 12 billion

at 10:00 by 10:00 this morning. And then

the LSM sees a message from me saying

I'm going to be paying JP Morgan $8

billion

by 10:00 this morning. But you don't

know about these other messages. Now the

LSM has three messages. One saying Jack

is paying Daryl 10. The other saying

Daryl is paying JP Morgan 8 and the

another message saying JP Morgan is

paying Jack 12. And you see that little

circle of payments. 10 81 12. So the LSM

can see that loop of payments and say,

you know what, Jack doesn't really need

to take 10 billion out of his his

account to make that payment to Daryl.

What we could do is we could credit his

account with the 12 billion from JP

Morgan at the same time that we debit

his account for the 10 billion paid to

Daryl. So net he gets 2 billion coming

in at 10:00 this morning. Did you notice

that? Uh did you notice that uh

cancellation your outgoing payment never

came out of your reserve balances. It

came it was cancelled against an

incoming payment to you of 12 billion

from JP Morgan. If you're showing

charge, yeah, the right hand side one is

the situation I just described with

different numbers. So there are three

banks, A, B, and C, and they're paying

each other these amounts. The LSM

notices there's this circle of payments,

and it simply cancels the largest amount

that it can cancel in this loop, which

is 20 billion. And that that means that

the banks didn't have to pay 20 billion

out of their out of their account. They

got 20 billion, and they paid 20 billion

by just cancelelling incoming against

outgoing. And you might say, well, kind

of that's kind of obvious. I mean, why

wouldn't why wouldn't you do that? Uh,

it's kind of natural, right? Well, you

need the software that detects these

loops. And the Fed doesn't have that

today. And so, all the banks, they can't

plan on these cancellations. They have

to start each day knowing that they have

enough to do it on their own with some

guesswork about incoming payments. And

what happens on a stress day like

September the 17th, 2019, there was a

record late payments. payments came into

the largest banks over 150 minutes later

than normal because everyone was holding

back, not knowing if they were going to

have enough to make their payments that

day. that was the that was the all-time

record in the in the surrounding years

uh for the data set that from some work

that I did with Adam Adam Copeland at

the New York Fed and Elen Yang who's at

the University of Minnesota we showed

that these stresses in money markets

arise when the banks are delaying their

payments because they don't have enough

balances to meet all their payment

needs. So if we were to if the Fed were

to introduce a liquidity savings

mechanism like the one illustrated uh

which is from the Bank of Japan then

banks wouldn't be as stressed. They

would be able to meet their payment

needs with much less reserve balances.

The Bank of England has a system that

does this also. It's called CHAPS. And

they've estimated a 20 to 30% saving in

the amount of reserve balances needed to

make payments. And whether that that

would be a bigger saving or a smaller

saving for the Fed, we don't know. But

I'm hoping to do some research on this.

I already have a theoretical uh paper

that shows why banks would want to do

this.

>> That's the piece that came your most

recent piece that came out earlier in

June.

>> Uh just came out. Yes. It's called

something like optimal liquidity savings

mechanisms and that's with uh Chao Wong

at the University of Pennsylvania and

Shrist Singh at the University of

Toronto.

>> We will link that paper as well. Darl,

as you referenced, you said people might

think this is obvious. I had that exact

same thought because when reading this

paper in preparation, I'll be honest, I

got a little nervous. These are like

very very complex ideas that are on the

cutting edge. Like many of them haven't

been implemented at least in the US.

Perhaps they've been implemented around

the world with other central banks of

foreign that that you work with and

advise as well. But this is deceptively

simple simple. Like isn't this the same

thing as like let's say we were coming

off a poker game and I owed you $100 and

you owed another professor at Stanford.

You owed Hannah Lustig $100. We would

just net it out and I would pay Hano

$100 instead of you me paying you a

hundred and you paying him a hundred.

>> Yeah. you probably wouldn't need to

bring as much cash to the game because

on average you're if you netted all this

out, you wouldn't need as much cash. And

and that's right. Uh if you do it in a

sequence of steps without doing these

netting cycles, you need more cash. And

that's been demonstrated both

theoretically and in empirically. The

Bank of Canada has this, the Bank of

England has this, the European Central

Bank has this, the Bank of Japan has

this, other central banks have it, but

the Fed, which runs the world's largest

payment system, does not have it. And so

it would be good at a minimum for the

Fed to investigate how much could they

save on reserve balances by introducing

a liquidity savings mechanism. I'm

presenting that paper at the New York

Fed next week and that's the main theme

of my presentation that the Fed should

investigate using their own data for

payments

and using you know the kinds of

approaches maybe maybe the one I

suggested in our paper or maybe one of

the conventional approaches used at the

other central banks and just do a test

run. Yes, it you know not not to add too

much commentary but I think people who

are not familiar with the banking system

at all when they first find out that the

way a bank makes a loan is just by

crediting the borrower with cash and

then suddenly a loan appears on the

asset side of the bank and a liability

in terms of a deposit. The cash that

they gave them that they lent them

appears as a deposit. Like I think it it

it blows people's minds. It blew my

mind, you know, when I first found that

out. But it seems like the deeper you

dive into the the sort of the guts of

the banking system, literally going to

the most, you know, priority level of

the of the Fed, it does seem like we

still are on a very hard money system,

particularly when it comes to reserves

of like, no, I need that. I need the

gold in my vault right now.

>> Yeah. Well, I mean, and these liquidity

savings mechanisms ultimately you still

need the gold in the vault. You uh and

the gold in this case is reserves held

at the Fed, but they're electronic

balances. And so with the with the the

miracles of software, you can economize

a lot on how much of that kind of gold

you need.

>> Okay. And you can you talk about other

you said Canada, I think talk about the

other central banks who have this and

just how far behind is the Fed in not

having this and then of course we have

some a few other charts that that may be

relevant here.

>> Well, it's one of those things where you

know the leading countries go first and

the other countries follow and leapfrog

and that's what's happened here. The Fed

was the first to introduce

real-time gross settlement, which means

this the kind of payment system that

we've been talking about, but they did

it before the introduction of liquidity

savings mechanisms. Then the other

central banks introduced this real-time

growth settlements uh coming after the

Fed and they realized this is kind of

expensive for in terms of the quantity

of uh reserves that are necessary to run

the system. They introduced liquidity

savings mechanisms. And the Fed, which

has had since the crisis at least, tons

and tons of reserves, never had to think

about it. But now that it's trying to

reduce its balance sheet, it should

start to think about maybe we should do

what the other central banks have done

and add these this new software.

>> Okay. So, professor, if people want to

and they should check out that that

again that is in the first paper which

is called the payment system puts a

floor on the Fed's balance sheet that is

in the section about the liquidity

mechanism. Let's talk about the final

one which is called the taring the

remuneration of reserves section six.

What's going on here?

>> Okay. Uh well, as you noted before the

financial crisis, the Fed did not pay

interest to banks on their on their

reserve balances. And and here's think

of yourself again as liquidity manager

at a very large bank. Maybe you're at a

city bank and you're looking at your

holdings of balances at the Fed. This is

2007 before the crisis. The Fed's not

paying you interest. And you've got, you

know, uh $5 billion sitting there in

reserve B. Well, actually in those days

you had much less. Say you have 500 $500

million sitting there. You're not

getting any interest on that money. What

are you going to do? Well, you're going

to try to cash it in for something that

pays interest. So, buy treasury bills.

Uh, you know, invest in something that

pays interest because why why would you

sit on on reserves that are not paying

interest? Okay. So with that motive,

banks hated to hold reserve balances

more than they need the more than the

minimum needed to run business in the

precrisis era. They hated to have

reserve balances. Now let's move to the

post crisis world where as you noted the

Fed is now doing monetary policy by

paying by setting the interest rate they

pay to banks and they set it at a rate

where they want the market to be

roughly. So if they say we want uh

market rates to be at 3 and a half%

today then they set the interest rate

they pay to banks at about three and a

half%.

Now you're you know it's it's uh 20

years later you're you're still the guy

running liquidity at City Bank and

you're saying well you know I've got5

billion sitting at the Fed but you know

that's fine because I'm earning three

and a half% interest. If I were to cash

it in for something in money markets,

I'd be getting about 3 and a half%. So,

no urgency. I'm happy to own those

reserve balances. That's great. And I

can use them to make payments or I can

just use them as an investment.

And in my paper, I note that JP Morgan

was holding hundreds of billions as an

investment that they did not need to

make payments a few years ago. They've

subsequently got rid of those because

it's no longer a great investment given

the term structure of interest rates.

But the data show that the banks really

don't worry much about having a lot of

reserve balances held to the Fed because

they're getting lots of interest.

So that that means there's a healthy

demand for reserve balances. They're

like the Swiss Army knife of finance.

They're good for everything. Meet

liquidity rags, make payments, great

investment, you're getting market rates.

What you know why not have them and load

up on them? Well, here's a way to

discourage that the demand for reserve

balances without messing up the system.

It was invented by the Reserve Bank of

New Zealand in 2007. That's the same

central bank that brought us the 2%

inflation target. So, they're an

innovator. And they said in 2007, you

know, if we want to implement monetary

policy by setting the deposit rate on

reserves, fine. But we don't have to pay

the same high rate no matter how much

balances a bank has. We could pay Jack's

bank the full market rate for the first

let's say required amount that he needs

to run his business and then once he has

more than he needs to run his business

we could drop the interest rate on the

rest to a lower level and in the case of

RBNZ was 100 basis points lower recently

as you can see in this chart on the left

hand side when the Reserve Bank of New

Zealand did that the banks in New

Zealand said well yeah I mean we need a

certain amount to run our business and

we're getting a market rate on that but

let's not hold any more than that

because why would we we can get you know

we could we could get rid of those extra

reserves and earn a higher interest rate

on on some uh securities. So by doing

this, the Reserve Bank of New Zealand

lowered the demand for reserve balances

without impairing its ability to

implement monetary policy and without

messing up the ability of banks to meet

their payment needs because they you

know they got full freight interest on

the amount they needed to run their

business and the rest they got a lower

rate but that they didn't need that

extra money anyway. I think you got the

idea. Several other central banks have

done this. uh Norisbank which is the

central bank of Norway

the South Africa central bank other

central banks have done this

and it's it's worked and it's enlivened

also the market for overnight borrowing

and lending between banks because if you

want to get rid of your extra balances

the easiest way is to lend them to

another bank that needs them and so you

get a better distribution of reserve

balances in a system you don't have to

load up every bank you just put as much

as you need in the system if you're the

central bank and then the banks will

sort it out by borrowing and lending in

the secondary market. That's not been

working well in the United States. The

secondary market for reserves which is

called the federal funds market is just

not working uh hardly at all. The

volumes are extremely low. So in order

to enliven the secondary market, get

better sharing of reserves and reduce

the demand for unneeded reserves, the

Fed could do what the Reserve Bank of

New Zealand did and just reduce the

interest rate on the unneeded part of

the reserve balances. That's easier said

than done because now you have to find

out for each type of bank, how much do

they actually need?

And my paper discusses that. And it is

it's not an easy problem, but it is

surmountable. And there are approaches

uh in the literature that describe how

to do it. And in fact, the Fed did it uh

for a brief period of time after the

failure of Lehman. It's not well known

that for a number of weeks after the

failure of Leman, the Fed ran exactly

this two-tiered system of remuneration.

You pay a higher interest rate on

required reserves and then a low

interest rate on the rest. And uh that

experiment was squashed by the financial

crisis because the Fed had to drop all

interest rates to zero, the zero lower

bound. And so the high tier rate and the

low tier rate both went to zero. And

then once rates reemerged into positive

territory, this

this two-tiered approach disappeared.

It's never come back, but it could come

back. And if it did, it would cause a

dramatic reduction in the demand for

reserve balances in the US system.

>> How much?

>> I don't know because I haven't I' I've

collaborating uh with two of our PhD

students.

Uh Franchesco Spitz Spitzu and Thanowat

Sornwani. We built a theoretical model

showing that it really works

theoretically, [laughter]

but we haven't calibrated it to the US

economy. So I can't tell you how much

the reduction would be. theoretically

you can get a very substantial reduction

in the demand for reserve balances which

is totally makes sense right because

when I ran through this little uh

vignette where you were the guy running

liquidity at your at City Bank it was

kind of obvious you didn't want to hold

more than required reserves because the

rest were getting compensated at a low

interest rate that and you could do

better by just uh converting the rest to

interestbearing securities. So, it

sounds like you're a little reticent to

give numbers, but theoretically, like

honestly, I would do it if I if I could,

but I can't. Uh, you know, do you leave

any breadcrumbs in the paper as to just

how large the potential reductions are

theoretically?

>> Not that I would be willing to put

numbers on uh and not other than to say

theoretically it could be quite

significant.

>> I see. Okay. Well, we'll say you started

with the quoteunquote least powerful

tool and you said that was maybe, you

know, a hundred billion or a few hundred

billion and so we're now at the last

tool. So, just to give people a sense of

that.

>> Yeah. Well, I mean, if I ordered them

correctly, this one is a lot more than

one or two hundred billion dollars.

>> Yes.

>> Yeah. But I'm not going to uh definitely

not going public with an estimate of the

quantity. There are there are other uh

subsequent research uh papers like for

example former governor Stephen Myron of

the Federal Reserve put out a paper and

I forget how much the number was but he

put a big number on this.

>> Yeah.

>> I mean a really big number.

>> Okay. So, professor because you are uh

very proficient in this topic as well as

these are you know your ideas that you

wrote about when you make these ideas

and you propose these to me and probably

to our audience they sound so simple and

uh like a very good idea and why would

you not do this you know Mr. Mr. Kevin

Worsh, why would why would you you not

do this? What could be the potential

drawbacks or push back that the Federal

Reserve, whether it's the new chair

Kevin Worsh or the old guard who kind of

put in these rules, particularly like

the Fed staff who have, you know, unlike

governors have been there for, you know,

perhaps over, you know, two decades or

something like that in terms of why

these four tools are so controversial to

uh to propose and difficult to to

implement.

>> Okay. So I'm very careful in my paper

and and anytime I speak about this

publicly to say that I am not saying the

Fed should reduce the size of its

balance sheet. My objective is to

provide options. If the Fed were to

decide to reduce its balance sheet, how

could it do it? And there are really

good arguments by others saying, well,

the Fed doesn't really need to reduce

its balance sheet. Nothing goes wrong

when there's extra reserves in the

system. Banks have lots of liquidity.

Markets are not going to go haywire.

Uh there's, you know, payment uh timing

is not an issue. We wouldn't need a

liquidity savings mechanism. Everything

would go great in the minds of of many

commenters with a large balance sheet

for the Fed. So many would say, well,

why go to all the trouble building a

liquidity savings mechanism? That's a

lot of retooling. Uh tearing down uh

reserve balances. That's, you know, you

have to figure out where you're going to

tear them down. The banks are not going

to be that happy because they're going

to make less profits on their on their

interest at uh on reserves held at the

Fed. They might lobby against this. Why,

you know, why go through all this

stress? Why not just keep the balance

sheet large? Many would say. And then

those that speak in the other direction

point to the fact that a very large Fed

balance sheet is kind of a political

lightning rod. those that are, you know,

not deep into the weeds are going to

say, "Well, why does the Fed need to own

so much assets?" This is where we

started the conversation. It doesn't

really need to own $6.5 trillion of

treasuries and mortgage back securities.

It's just it's going too far. It's it's

it's expanded beyond its needs. It's and

maybe they would even uh suspect that

the Fed is meddling in fiscal policy,

>> right? I certainly he heard those

arguments and yes, so thank you for

saying that and to be clear, you are not

making a prescriptive claim that the Fed

should do this, the Fed should do that.

It's like if you know there's a new

president or or uh you know person in in

the country who says we need to build

every single semiconductor that America

consumes, we need to build here. You're

not saying that's a good idea or that's

a bad idea. You're saying if the

president has this agenda, here is how

much electricity we need. Here's how

many fabs we need. That that's what

you're doing. Okay. Now, with that being

said, the new Fed chair, Kevin Worsh,

has been extremely open about his desire

to reduce the Fed's balance sheet and

the fact that he thinks that the Fed

should not be in the business of having

a large balance sheet or I believe to to

paraphrase that the you know, Fed is

involved in credit provision and that

it's it's its um what's it called? Its

profile in the market should be a a lot

more reduced. So, you're not on the

record saying the Fed should do this,

the Fed should do that. the guy running

the Fed is on the record, at least

before he ran the Fed, that this is what

the Fed should do. So, these are your

four proposals. How receptive do you

think the leadership of the Fed as well

as the other uh board of governors, the

presidents, the research staff are to

these ideas generally?

>> Well, I've had conversations, but I'm

not going to report on those. But there

are public remarks by several uh members

of the FOMC and including governors and

presidents on this topic and they are

it's a mixed bag of views about how

important it is to reduce the balance

sheet. Some uh you know much more

interested than others. Uh Governor

Chris Waller for example has said uh

having abundant reserves is not a

problem. If we want to reduce the

balance sheet, I'm I'm paraphrasing,

then we shouldn't do it without reducing

the demand for reserves first because

why would you cause the costs of

insufficient reserve balances? He

likened it to banks. He used the

interesting metaphor. He said, why would

you have banks scrging and under the

couch cushions for money? He said,

quote, that would be massively stupid

and inefficient.

And that and what he meant by that is if

we're going to reduce the balance sheet,

we shouldn't make it hard for banks to

get the reserve balances they need. We

would have to reduce the amount of

reserve balances that they need. Uh

other uh you know uh uh President Lori

Logan, the president of the Dallas Fed,

wrote a paper with Sam Schuler Woler

describing technically what would need

to be done. It's sort of analogous to

the paper that I wrote. Uh former

Governor Steven Myron also wrote a paper

uh going through the options. Uh

Governor Michael Bar has ventured

opinions on this. He's less concerned

about the size of the Fed's balance

sheet, but he's also indicated, you

know, that if we're if if this is going

to be done, there are better and worse

ways to do it.

Um and so on. So there are mixed there's

a mis mixed range of views at the Fed.

My my view is it's not simply providing

options uh in my paper. It's not purely

a clinical kind of plumbing paper. I

also have the view that the Fed should

develop these options in case they're

needed. So even if the Fed doesn't

currently have any plans to reduce its

balance sheet, it should have these

options available. What if, for example,

what if Congress said to the Fed, "We

think you're too big for your britches.

We want you to cut down your balance

sheet by 20%."

The Fed currently has no options that

would allow that. And if Congress said,

"Oh, you can't do that, why not? Uh, and

uh, if you're going to hold all these

assets, maybe you should hold some

assets that we want you to hold instead

of the assets that you want to hold."

And that would be eroding the Fed's

independence, right? if if Congress were

to use the size of the Fed's balance

sheet uh as kind of leverage or as a way

to conduct fiscal policy. So the Fed

needs to have these options available in

case, you know, it becomes a break the

glass situation and they have to reduce

their their balance sheet. And now it

may, you know, with chair chair wars has

impanled a task force on the Fed's

balance sheet, it may become a matter of

policy eventually that it will reduce

its balance sheet. Uh so having these

options, developing these options, doing

research on them, measuring how

effective they are, answering some of

the questions that you asked me uh

today, how many hundred billion for

this, how many hundred billion for that?

Th you know that research should be done

at the Fed in my view.

>> Are you going to be involved in the task

force on the Fed's balance sheet? Would

you like to be if you're not?

>> Don't know.

>> Maybe they should. I mean, you're you're

kind of the guy. I mean, you've got some

uh people should people should read this

paper. Uh are there any ideas that

people have, other academics,

economists, Fed people have that you

didn't include because you think there

are drawbacks that maybe they weren't

considering? There's a there's a longer

list in uh Governor Myron's paper with

collaborators at the Federal Reserve

Board when he was when he uh when he was

there and uh I don't remember what they

all are but you know I think I think the

ones that I've listed with you today are

the are probably the most important ones

to consider.

>> Okay. So you think if you know hopefully

we do another interview and um the

reserves of the Fed in let's say 2028

instead of 3.07 07 trillion are 1.07

trillion. You think it is likely that

they will have used

several or all of the tools that we

talked about today?

>> I'm I'm going to venture that by 2028

you that that's not going to happen.

It's that's way more reduction than

could happen by that time. As I

mentioned, the easier ones are not that

potent. If you really want to get a lot

of reserve balances, it goes down to

these things like liquidity savings

mechanisms and tiering the remuneration

of reserves and those take years to

develop. So you know maybe add a few

years to what what you said and and then

yes maybe

>> and the liquidity saving mechanisms and

the tiering reserves to summarize other

central banks have done this

successfully.

>> Correct.

>> Okay.

>> But other central banks are not the Fed.

Fed is special. It's big and it's

different. Uh so I'm not suggesting that

the Fed is going to go this way, but if

it really wants to get its balance sheet

down a lot, it may well need to consider

uh going this way.

>> And what if it's not 2028, but it's 2033

and there's a substantial reduction in

reserves. What does that world look

like? The Fed has achieved its goal.

It's reduced reserves and therefore

reduced its assets, reducing

liabilities, reducing assets. But what

might the consequences be? I think you

said one of heightened interest rate

volatility. Are there other

consequences?

>> Yeah, I mean the Fed will have a smaller

balance sheet. It'll be less at risk of

coming into

uh under a bright light uh from

commentators who are concerned about the

size of the Fed's balance sheet because

they don't understand what's causing it

to be so big. If it's smaller, then that

just basically alleviates those

concerns. the Fed will be in a better

position, at least politically, if

another crisis comes along and it needs

to expand its balance sheet

dramatically, let's say, to to manage a

dysfunction in the Treasury market, if

it needs to buy a few trillion of of

treasuries, that would be much more

politically palatable when the balance

sheet starts at a small level than when

the balance sheet starts uh you know at

6.5 trillion and growing with the

current uh framework. So yeah, I mean

the Fed will be in a much better

position at that time with respect to

those issues.

>> Daryl, thank you so much for joining. We

will link to your papers which are

available at daryl duffy.com. The one we

discussed mainly came out in the spring

of 2026, the payment system puts a floor

in the Fed's balance sheet and your

piece that came out just came out in

June of this year, an efficient

liquidity savings mechanism. Thank you.

And uh sounds like the Feds wants to be

involved. Maybe maybe they should uh

they should contact you. Thank you.

Thank you again, Professor

>> Jack. It's always a pleasure. Thank you

for having me.

>> I hope you enjoyed today's interview.

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