Powell: Fed will start slowing balance sheet runoff 'fairly soon'

Bloomberg News

WASHINGTON — The Federal Reserve will soon begin to taper its balance sheet reduction efforts, but that doesn't mean the runoff campaign is coming to a close.

Following this week's Federal Open Market Committee meeting, Fed Chair Jerome Powell said a slower pace of runoff will be coming "fairly soon," noting that the effort will likely center on a lower runoff cap on Treasuries. 

"While we did not make any decisions today on this, the general sense of the Committee is that it will be appropriate to slow the pace of runoff fairly soon, consistent with the plans we previously issued," Powell said during the opening statement of his post-meeting press conference. "The decision to slow the pace of runoff does not mean that our balance sheet will ultimately shrink by less than it would otherwise, but rather allows us to approach that ultimate level more gradually."

Since the summer of 2022, the Fed has allowed $95 billion of assets on its balance sheet to mature each month without purchasing new securities to replace them. Since this exercise began, the Fed has reduced its balance sheet by nearly $1.5 trillion.

When the Fed reduces assets on its balance sheet, it mechanically destroys liabilities as well — including reserves, which banks hold at the central bank and use for settling transactions with one another. 

Powell said the goal of a slower runoff is to make sure the process does not drain reserves too quickly. He noted that there are broadly enough reserves in the system now for it to function smoothly, but said some banks hold a bigger share of those reserves than others.

"Liquidity is not evenly distributed in the system, and there can be times when, in the aggregate, reserves are ample or even abundant, but not in every part," he said. "In those parts where they're not ample, there can be stress, and that can cause you to prematurely stop the [runoff] process to avoid the stress, and then it would be very hard to restart."

The announcement comes as another key Fed liability, the overnight reverse repurchase, or ON RRP, facility — a program through which money market funds and other nonbank entities can park securities at the Fed in exchange for a modest return — has remained below $500 billion since the beginning of the month. The facility, which routinely saw more than $2 trillion of uptake between 2022 and 2023, is regarded as an indication of excess liquidity in the financial system. It has fallen steadily since the runoff effort began.

"We're going to be monitoring carefully money market conditions and asking ourselves what they're telling us about reserves," Powell said. "Right now, we would characterize them as abundant, and what we're aiming for is ample, which is a little less than that."

Politics and policy

How big should the Fed's balance sheet be?

September 5, 2023 3:35 PM

Powell said the reduction effort would begin with the Treasuries portion of the runoff, which accounts for $60 billion of the monthly cap. The other $35 billion is in mortgage-backed securities, but Powell noted that the Fed is not regularly hitting the cap, as mortgage-backed securities mature less frequently.

Powell noted that the FOMC's long-term goal is to have the assets that the Fed holds be primarily Treasury securities, with minimal mortgage-backed securities. This echoes a sentiment expressed regularly by Fed Gov. Christopher Waller, who has called for reducing the central bank's mortgage holdings to zero. 

"I do expect that once we're through this, we'll come back to the other issues of composition and maturity, and revisit those issues," Powell said. "That's not urgent right now."

During this week's meeting, the FOMC voted to hold the target range for the federal funds rate steady at between 5.25% and 5.5%, the same level it has been at since July. The move, which received unanimous support from the committee's 12 voting members, was broadly anticipated by financial market participants.

In its policy statement, the FOMC reiterated its stance that the inflation has eased but it will not cut its benchmark rate until it is confident inflation is moving "sustainably" toward its 2% target. 

The statement also noted that the committee is uncertain about the nation's economic outlook and "attentive to inflation risks." It also noted that the risks associated with the two legs of its dual mandate — maintaining maximum employment and stable prices — were moving into "better balance," meaning that as elevated rates continue to tamp down inflation, they could threaten the labor market.

During this week's meeting, members of the Federal Reserve Board and the presidents of the 12 regional reserve banks wrote down their forecasts for the months and years ahead in FOMC's quarterly summary of economic projections. Fifteen of the 19 participants expect the federal funds rate to fall below 5% by the end of the year, with a nine-member plurality writing down a terminal range of between 4.5% and 4.75%. 

All but one participant said they expect rates to be meaningfully lower in 2025, with most expecting the benchmark rate to drop below 4% by the end of the year. The lone outlier expects the target range to remain at its current level. These views are largely unchanged from the FOMC's last summary of economic projections in December. 

Further out, more participants are projecting higher long-term rates. Eleven officials said they anticipate rates being 2.75% and 3.25%, compared to eight in December. Similarly, seven members called for longer-run rates of 3% or higher this month, while only four forecasted rates above that level at the end of last year. 

This shift toward higher rates corresponds with a growing belief among the committee that price growth will remain above the Fed's 2% target for longer than previously expected. Five participants forecasted an inflation rate between 2.1% and 2.2% in 2026, up from just one in December. 

Over the longer run, all voting members said they expect price growth to return to 2%.