Reducing Reserves: Steps taken by Fed and ECB

Fed and ECB to Reduce Bank Reserves by 90% in Response to High Rates

Both the Federal Reserve (Fed) and the European Central Bank (ECB) are planning to reduce the amount of money they have pumped into banks over the past decade, according to a recent article by a Fed economist. This move comes as inflation and interest rates rise, making the extra liquidity unnecessary.

In order to combat inflation, the world’s two largest central banks have been raising interest rates rapidly. They are also easing off on the massive bond purchases that have flooded banks with cash when price growth is stagnant and borrowing costs are already at zero.

The Fed document, which will be presented to senior central bankers at the ECB’s annual meeting in Portugal next week, delves into the question of how much cash the Fed and ECB should currently hold in the banking system to meet reserve demand. It suggests that monetary incentives are no longer needed.

The author, who is a senior adviser to the Federal Reserve Board, estimates that the Fed could reduce its total reserves from the current $6 trillion to a range of $600 billion to $3.3 trillion.

On the other hand, U.S. Treasuries and German government bonds are highly sought after in the market due to their liquidity and security. This means that banks have less incentive to exchange them for deposits at the central bank.

Similarly, the ECB could reduce its own liquidity supply from the current 4.1 trillion euros ($4.51 trillion) to either 521 billion euros if it only accepts German government bonds, or to 1.4 trillion euros for other assets.

These proposed reductions in bank reserves by the Fed and ECB indicate their confidence in the economy’s ability to handle higher interest rates and potentially combat inflation. However, it remains to be seen how this decision will affect financial markets and the overall economy in the long run.

 

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