How the Federal Reserve got so huge, and why and how it can shrink

Abstract

AbstractFollowing the collapse of Lehman Brothers in September 2008, the Federal Reserve underwent a significant shift in how it implemented monetary policy, transitioning to an excessive‐reserves framework that it had deemed too radical and rejected just months prior. This shift involved borrowing excessive reserves from banks, deviating from its traditional method of borrowing only the amount banks needed to meet reserve requirements and address clearing needs. Despite initial intentions to revert to the necessary‐reserves framework, subsequent developments, including three rounds of quantitative easing, led to the permanent adoption of the excessive‐reserves approach in January 2019 by the Federal Open Market Committee (FOMC). This decision was a mistake. The framework has not yielded the purported benefits, such as simpler policy implementation, and has required the Fed to be vastly larger than originally anticipated. Advocates of the excessive‐reserves approach argue it aligns with the Friedman rule, but alternatives like a voluntary‐reserve‐requirement regime could achieve similar outcomes without the drawbacks.