Federal Reserve Board research sets out a balance-sheet trilemma linking reserve supply, rate volatility and market intervention

The Federal Reserve Board published a FEDS Note proposing a “balance sheet trilemma” for determining the steady-state size and behavior of a central bank balance sheet. The note argues that policymakers can achieve only two of three objectives at once: a small balance sheet, low volatility of short-term interest rates, and limited intervention in money markets, framing the tradeoff as the Federal Reserve moves from its recent balance-sheet reduction to reserve management purchases aimed at maintaining ample reserves. The authors link the tension to nonlinear and uncertain demand for reserves and to sudden swings in liquidity supply and demand, including changes in the Treasury General Account, Overnight Reverse Repo (ON RRP) and the foreign repo pool, as well as payment flows and quarter-end effects. With thinner reserve buffers, money-market rates become more sensitive to such shocks, implying that a smaller balance sheet either allows larger rate moves or requires more frequent operations, while avoiding both outcomes implies a larger steady-state level of reserves. The note sets out the costs of each margin, including a larger central bank footprint and potential crowding out of private money-market activity under a large balance sheet, weaker rate control and potential funding stress under high volatility, and operational challenges and potential distortions to market discipline from frequent interventions through open market operations or standing facilities such as the Standing Repo Facility, ON RRP and the Discount Window.