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Powell's speech is cautious and "dovish"; the "tapering" may end in the coming months.
Organization: Golden Finance
On Tuesday, local time in the United States, Federal Reserve Chairman Jerome Powell attended the annual meeting of the National Association for Business Economics (NABE) held in Philadelphia, Pennsylvania, and delivered an important speech on the current economic situation and future policy expectations.
Powell stated that the Federal Reserve may end its balance sheet reduction in the coming months. The future direction of monetary policy will be driven by data and risk assessments, and the balance sheet remains an important tool of monetary policy, with an early cessation of balance sheet expansion potentially having a minor impact. The risks in the labor market are rising, making a rate cut in September reasonable. Labor market expectations still show a downward trend. Powell mentioned that everyone is focusing on the same unofficial employment data, with state-level unemployment claims being a good data point. He believes that if the government shutdown continues and the October data is delayed, the Fed will start to miss data, making the situation more complicated.
Powell added that even without new labor statistics data (delayed due to the government shutdown), privately produced employment market indicators and internal Federal Reserve research provide sufficient reason to indicate that the job market is cooling. "Current evidence" suggests that "layoffs and hiring numbers remain very low," while "households' views on job opportunities and businesses' views on hiring difficulties continue to trend downward."
Powell also stated that, despite the lack of the latest data due to the ongoing government shutdown, the U.S. economy still appears to be in a stable condition. On economic issues, Powell reiterated the theme from his recent remarks, stating that "there is no policy path that is risk-free in the tension between employment and inflation targets."
Nick Timiraos, the "Fed's mouthpiece," commented that Federal Reserve Chairman Powell's speech regarding the balance sheet did a few things: 1) In light of the recent signs of rising overnight borrowing rates, the speech provided a market-based assessment of the current quantitative tightening outlook; 2) It rebuffed recent criticisms (such as from U.S. Treasury Secretary Yellen and others) that the support measures during the pandemic—implemented with broad support in Congress and the early Trump administration—were absurd policy interventions. Powell acknowledged (as he had before) that it would have seemed wiser to stop quantitative easing sooner, but given how quickly and sharply the Fed changed course in 2022, this move had no substantive impact on the macroeconomy. 3) It also defended the efforts of bipartisan populist senators to strip the Fed of its ability to pay interest on excess reserves (IOR), warning that revoking this policy tool could cause greater disruption to the markets.
Sparta Capital Securities Chief Market Economist Peter Cardillo stated that he does not believe Powell has changed his tone. On one hand, he says that the economic fundamentals are solid, but he also points out that there are weaknesses. What he is doing is preparing the market for a series of rate cuts, but not necessarily in order. Peter Cardillo believes that Powell's remarks suggest that he will cut rates by 25 basis points at the end of this month, and then the Federal Reserve will assess the situation. If the labor market continues to weaken, leading to job reductions, then he may prepare for a significant cut of 50 basis points in December. Powell is preparing the market for rate cuts, but at the same time, he does not want the market to think that rate cuts are inevitable. He is using the weakness of the labor market as a hedge.
The following is the full text of Powell's speech:
Thank you, Emily. I would also like to thank the National Association for Business Economics (NABE) for awarding me the Adam Smith Award. It is a great honor to receive this award alongside past winners such as my predecessors Janet Yellen and Ben Bernanke. I appreciate your recognition and thank you for giving me the opportunity to speak with everyone today.
When the public understands the functions of the Federal Reserve and the reasons behind its operations, monetary policy can be more effective. With this in mind, I hope to enhance everyone's understanding of a relatively obscure and technical aspect of monetary policy—the Federal Reserve's balance sheet. A colleague recently likened this topic to going to the dentist, but this comparison may be unfair to dentists.
Today, I will discuss the important role our balance sheet played during the pandemic, as well as some lessons learned. Then, I will review our ample reserve implementation framework and the progress we have made in normalizing the size of our balance sheet. Finally, I will briefly talk about the economic outlook.
Background of the Federal Reserve's Balance Sheet
One of the main responsibilities of the central bank is to provide the monetary base for the financial system and the broader economy. This base consists of the liabilities of the central bank. As of October 8, the total liabilities of the Federal Reserve's balance sheet amount to $6.5 trillion, with three categories accounting for approximately 95% of the total. First, Federal Reserve notes (i.e., physical currency) total $2.4 trillion. Second, reserves (the funds held by depository institutions at Federal Reserve banks) total $3 trillion. These deposits enable commercial banks to make payments and receive funds, as well as meet regulatory requirements. Reserves are the safest and most liquid assets in the financial system, and only the Federal Reserve can create them. A sufficient supply of reserves is essential to ensure the safety and soundness of our banking system, the resilience and efficiency of the payment system, and ultimately, economic stability.
The third is the Treasury General Account (TGA), which is currently about $800 billion and essentially serves as the federal government's checking account. When the Treasury pays out or receives funds, these cash flows affect the supply of reserves or other liabilities in the system.
Almost all of the assets on our balance sheet are composed of securities, including $4.2 trillion in U.S. Treasury bonds and $2.1 trillion in government-sponsored mortgage-backed securities (MBS). When we increase reserves in the system, we typically do so by purchasing Treasury bonds in the open market and depositing them into the reserve accounts of the banks that trade with the seller. This process effectively converts publicly held securities into reserves, but does not change the total amount of government debt held by the public.
The balance sheet is an important tool
The Federal Reserve's balance sheet is a key policy tool, especially when the policy interest rate is constrained by an effective lower bound (ELB). In March 2020, when the COVID-19 pandemic broke out, the economy was nearly brought to a standstill, and financial markets became paralyzed, leading to a public health crisis that could evolve into a severe and prolonged economic recession.
In response, we have established a series of emergency liquidity tools. These initiatives have received support from Congress and the government, providing crucial backing for the market and playing a significant role in restoring confidence and stability. During the peak period in July 2020, the total amount of loans from these tools was slightly over $200 billion. As the situation stabilized, most of these loans were quickly repaid.
At the same time, the U.S. Treasury market—typically the deepest and most liquid market in the world, and a cornerstone of the global financial system—is under immense pressure, on the brink of collapse. We are restoring normal operations in the Treasury market through large-scale purchases of securities. In the face of unprecedented market dysfunction, the Federal Reserve rapidly purchased U.S. Treasuries and agency securities in March and April 2020. These purchases supported the flow of credit to households and businesses and created a more accommodative financial environment to support economic recovery. This policy easing is crucial, as we have lowered the federal funds rate to near-zero levels and expect it to remain at this level for some time.
By June 2020, we slowed the pace of bond purchases but still maintained a scale of $120 billion per month. In December 2020, given the highly uncertain economic outlook, the Federal Open Market Committee indicated that it expected to maintain this pace of purchases "until the Committee sees substantial further progress toward its maximum employment and price stability goals." This guidance indicates that the Federal Reserve will not prematurely withdraw support as the economic recovery remains fragile and faces unprecedented conditions.
We maintained the asset purchase pace until October 2021. By then, it had become clear that without a strong monetary policy response, high inflation was unlikely to subside. At the November 2021 meeting, we announced a gradual reduction in asset purchases. At the December meeting, we doubled the pace of the reduction and stated that asset purchases would end in mid-March 2022. Throughout the bond-buying period, our securities holdings increased by $4.6 trillion.
Some observers have raised reasonable doubts about the scale and composition of asset purchases during the pandemic recovery. In 2020 and 2021, due to the consecutive outbreaks of COVID-19, there was widespread chaos and loss, and the economy continued to face significant challenges. During that tumultuous period, we continued asset purchases to avoid a sharp and unpleasant tightening of financial conditions while the economy remained highly vulnerable. Our thinking was influenced by some recent events, in which signals of balance sheet reduction led to a significant tightening of financial conditions. We recalled the situation in December 2018, as well as the "taper tantrum" of 2013.
Regarding the composition of our asset purchases, some have questioned why we are still buying Agency Mortgage-Backed Securities (MBS) during a period of strong real estate market recovery post-pandemic. Apart from purchases specifically aimed at market operations, the main purpose of MBS purchases, similar to our purchases of government bonds, is to alleviate broader financial conditions when policy rates are constrained at the Effective Lower Bound (ELB). During this period, the extent of the impact of these MBS purchases on the real estate market conditions is difficult to determine. Many factors influence the mortgage market, and many factors outside the mortgage market also affect the supply and demand dynamics of the broader real estate market.
In hindsight, we could have - and perhaps should have - stopped asset purchases earlier. Our real-time decisions at the time were aimed at preventing downside risks. We understood that once we stopped purchases, we could relatively quickly reduce the size of our balance sheet, and that indeed turned out to be the case. Research and experience show that asset purchases influence the economy by shaping expectations about the future size and duration of the balance sheet. When we announced the tapering of quantitative easing, market participants began to digest its impact, thus tightening financial conditions in advance. Stopping earlier might have led to some changes, but it was unlikely to fundamentally alter the economic trajectory. Nevertheless, our experiences since 2020 have shown that we can use the balance sheet more flexibly and with greater confidence, as market participants have become increasingly familiar with these tools, and our communication can help them form reasonable expectations.
Some people also believe that we could have clarified the purpose of asset purchases more clearly. There is always room for improvement in communication. However, I think our statement has fairly clearly articulated our goals, which are to support and maintain the smooth functioning of the market, as well as to help create a loose financial environment. Over time, the relative importance of these goals has changed with the economic conditions. But these goals have never been in conflict, so at that time, the issue did not seem to make much difference. Of course, that is not always the case. For example, the banking pressures in March 2023 led to a significant increase in our balance sheet through loan activities. We have clearly distinguished these financial stability operations from our monetary policy stance. In fact, we were still raising policy rates during that period.
The sufficient reserve system is operating well
Speaking of my second topic, it turns out that our ample reserve system is very effective in managing our policy interest rates well under various challenging economic conditions, while also promoting financial stability and supporting a robust payment system.
Under this framework, a sufficient supply of reserves ensures adequate liquidity in the banking system, while the control of policy interest rates is achieved by setting our regulated rates (the reserve balance rate and the overnight reverse repo rate). This approach allows us to maintain interest rate control without being affected by the size of the balance sheet. This is crucial given the significant volatility and unpredictability of private sector liquidity demands, as well as the substantial fluctuations in autonomous factors affecting reserve supply (such as the Treasury General Account).
Regardless of whether the balance sheet is shrinking or expanding, this framework has proven resilient. Since June 2022, we have reduced the size of the balance sheet by $2.2 trillion, from 35% of GDP to just below 22%, while maintaining effective interest rate control.
Our long-standing plan has been to halt the reduction of the balance sheet when reserves are slightly above what we consider consistent with adequate reserve conditions. We may approach this point in the coming months, and we are closely monitoring various indicators to make this decision. Some signs have begun to emerge indicating that liquidity conditions are gradually tightening, including a general strengthening of repurchase rates and more pronounced but temporary funding pressures on specific dates. The committee's plans indicate that they will take cautious measures to avoid a situation similar to the monetary market tensions of September 2019. Furthermore, the tools within our implemented framework, including the standing repurchase facility and the discount window, will help manage financing pressures and keep the federal funds rate within the target range during the transition to lower reserve levels.
The normalization of the balance sheet size does not mean returning to pre-pandemic levels. In the long term, the size of our balance sheet depends on the public's demand for our liabilities, rather than pandemic-related asset purchases. Currently, non-reserve liabilities are approximately $1.1 trillion higher than before the pandemic, thus requiring an increase in our securities holdings accordingly. The demand for reserves has also risen, which partially reflects the growth of the banking system and the overall economy.
Regarding the composition of our securities investment portfolio, in relation to the issued government bonds, our current portfolio has a higher allocation to long-term securities and a lower allocation to short-term securities. The long-term securities allocation will be discussed by the committee. We will gradually and predictably transition to our desired portfolio so that market participants have time to adjust and minimize the risk of market volatility. In line with our long-standing guidelines, our goal is for the portfolio to be primarily composed of government bonds in the long term.
Some have questioned whether the interest on the reserves we pay will impose a heavy burden on taxpayers. That is not the case. The Federal Reserve's interest income comes from U.S. Treasury securities that support the reserves. In most cases, the interest income we receive from the U.S. Treasury securities we hold is sufficient to pay the reserve interest, resulting in substantial remittances to the Treasury. According to legal provisions, after covering expenses, all profits must be remitted to the Treasury. Since 2008, even accounting for recent negative net income, the total amount we have remitted to the Treasury has exceeded $900 billion. Although our net interest income is temporarily negative due to the rapid increase in policy rates to control inflation, such a situation is extremely rare. Our net income will soon turn positive, as has been the case historically. Of course, negative net income does not affect our ability to implement monetary policy or fulfill our financial obligations.
If we cannot pay the interest on reserves and other liabilities, the Federal Reserve will lose control over interest rates. The stance of monetary policy will no longer be appropriately adjusted based on economic conditions, causing the economy to deviate from our employment and price stability goals. To restore interest rate control, a large amount of securities needs to be sold in the short term to reduce our balance sheet and the amount of reserves in the system. The quantity and speed of these sales may put pressure on the operation of the Treasury market and jeopardize financial stability. Market participants need to absorb the sale of Treasury bonds and agency MBS, which will create upward pressure on the entire yield curve, thus increasing borrowing costs for the Treasury and the private sector. Even after undergoing this tumultuous and destructive process, the resilience of the banking system will still decline, making it more susceptible to liquidity shocks.
Most importantly, it has been proven that our ample reserve system is very effective in implementing monetary policy and supporting economic and financial stability.
Current Economic Situation and Monetary Policy Outlook
Finally, I will briefly discuss the current economic situation and the outlook for monetary policy. Although some important government data has been delayed due to the government shutdown, we will regularly review various public and private sector data that is still available. We have also established a nationwide network of contacts through the Reserve Banks, which provides valuable insights that will be summarized in tomorrow's Beige Book.
Based on the data we currently have, it can be said that there has not been much change in the employment and inflation outlook since the September meeting four weeks ago. However, the data obtained before the government shutdown shows that the growth trend in economic activity may be more robust than expected.
Despite the unemployment rate remaining low in August, the growth in employment numbers has significantly slowed, partly due to a decrease in immigration and a decline in labor force participation leading to a slowdown in labor growth. In this lackluster and somewhat weak labor market, the downside risks to employment seem to have increased. Although official employment data for September has been delayed, existing evidence indicates that both layoffs and hiring activities remain low, with households’ perceptions of job opportunities and businesses’ perceptions of hiring difficulties continuing to decline.
At the same time, the core personal consumption expenditure (PCE) inflation rate for 12 months in August was 2.9%, slightly higher than earlier this year, as the pace of core goods inflation outpaced the ongoing tightening of housing services prices. Existing data and surveys continue to indicate that the rise in commodity prices mainly reflects tariff impacts rather than broader inflationary pressures. Consistent with these impacts, short-term inflation expectations have generally risen this year, while most long-term inflation expectation indicators remain aligned with our 2% target.
The rising risk of employment downturn has changed our assessment of risk balance. Therefore, we believe it is appropriate to adopt a more neutral policy stance at the September meeting. As we strive to balance the tension between employment goals and inflation targets, there is no risk-free policy path. This challenge is evident in the differences in the predictions made by committee members at the September meeting. I want to emphasize again that these predictions should be understood as a range of potential outcomes, the probabilities of which will change as new information emerges, thus affecting our decision-making process at each meeting. We will formulate policies based on the evolution of the economic outlook and risk balance, rather than following a predetermined path.
Thank you again for presenting this award, and thank you for inviting me to share with you today. I look forward to communicating with you.