The Fed’s balance sheet needs a buffer. How big should it be?

The estimated buffer between an “ample” and “scarce” level of bank reserves on the Federal Reserve’s balance sheet may be relatively small, according to new Cleveland Fed research by economist Joe Haubrich.

But the ongoing reduction in the size of the balance sheet bears watching, as other analytical methods produce some considerably higher estimates of the needed buffer, Haubrich writes in a new Economic Commentary.

It’s unclear how far quantitative tightening (QT) can go before the amount of money banks hold at the Federal Reserve drops too low and falls into the “scarce” range. Haubrich cites estimates from other researchers putting that threshold somewhere between $900 billion to $3.8 trillion.

The buffer needed beyond that level may be “relatively small” by comparison, Haubrich writes. He uses evidence based on inventory theory to analyze bank reserve levels going back to December 2015.

“I estimate an optimal buffer of around $90 billion to $130 billion. Other estimates from the inventory model that include possible demand shocks can lead to higher numbers in the range of $800 billion to $860 billion. This range of estimates reveals considerable uncertainty about the size of the needed buffer,” he writes.

Treating the balance sheet as inventory provides a useful way to estimate trade-offs the Federal Open Market Committee will face as QT continues, Haubrich notes.

“This problem is akin to deciding how early to arrive at the airport. Getting there too early means wasting time at the airport, but arriving too late means possibly missing the flight. The key is to choose a buffer that addresses the two costs by finding a balance between letting the federal funds rate get too high versus having a larger balance sheet,” he writes.

Read the Economic Commentary: QT, Ample Reserves, and the Changing Fed Balance Sheet