Powell Opens Door to Rate Cuts: Little Change in Outlook Since September Meeting, Significant Downside Risks to Employment, Balance Sheet Reduction May Be Nearing an End

"New Fed News Agency": Powell keeps the Fed on track for another rate cut.

Written by: Li Dan

Source: Wallstreetcn

In his last public speech on the economy and monetary policy before the Fed's blackout period at the end of this month, Fed Chair Jerome Powell hinted that the U.S. labor market continues to deteriorate. Despite the government shutdown affecting economic assessments, he left open the possibility of a rate cut this month. He also stated that the Fed may stop reducing its balance sheet—quantitative tightening (QT)—in the coming months.

In his prepared remarks at this year's National Association for Business Economics (NABE) annual meeting, Powell said that since last month's Fed policy meeting, there has been little change in the U.S. employment and inflation outlook. He noted that while some key economic data releases were delayed due to the federal government shutdown,

"Based on the data we have, it is fair to say that since our September meeting four weeks ago, the outlook for employment and inflation appears to have changed little."

Powell then pointed out that pre-shutdown data suggested economic growth may be slightly more robust than expected. The unemployment rate remained low in August, and wage growth slowed significantly, possibly partly due to reduced immigration and a declining labor force participation rate leading to slower labor force growth.

"In this lackluster and somewhat weak labor market, downside risks to employment seem to have increased."

In his speech, Powell reiterated that because downside risks to employment have increased and the Fed's assessment of the risk balance between its employment and inflation goals has changed, the Fed decided to cut rates in September. To address the tension between the dual mandate, "there is no risk-free policy path." He mentioned that current data and surveys still indicate, "the rise in goods prices mainly reflects tariffs, rather than broader inflationary pressures."

During the Q&A session, when asked whether tariffs would have a slow and persistent impact on inflation, Powell acknowledged that tariffs are a risk, but pointed out that there is a "substantial" downside risk in the labor market. The labor market is slightly undersupplied.

Powell said the Fed is trying to balance the risks of actions taken to achieve its dual mandate of employment and inflation. Cutting rates too quickly could "leave the inflation task unfinished," while cutting too slowly could "cause severe damage to the job market." He again emphasized that the interest rate path is not risk-free, saying:

"There really is no risk-free path right now, because (inflation) seems to be continuing to rise slowly... and now the labor market is showing considerable downside risk. Both labor supply and demand have dropped sharply."

Powell said that although the labor market is weak, economic data is "unexpectedly positive."

Powell repeatedly noted the slow pace of hiring on Tuesday and pointed out that employment rates may fall further. He said: "The number of job vacancies has further declined, which is likely to be reflected in the unemployment rate. After a period of straight decline, I think, eventually, we will reach a point where the unemployment rate starts to rise."

Powell did not give specific numbers on where he sees the breakeven point for employment growth, that is, the minimum level needed to keep the unemployment rate stable. He said the unemployment rate has clearly "declined significantly." He noted that with slowing employment growth, the unemployment rate has barely changed, which is "very striking."

Nick Timiraos, known as the "New Fed News Agency" reporter, wrote that Powell keeps the Fed on track for another rate cut. He hinted that despite inflation concerns, a rate cut this month is still possible due to a weak job market.

Economist Chris G. Collins commented that Powell's statement that the outlook has not changed much since the September meeting is consistent with the expectation of two more rate cuts this year announced after the September meeting. However, he did not send a strong signal for a rate cut this month, instead pointing out that "the trajectory of economic growth may be slightly stronger than expected."

Ample Reserves, Signs of Tightening Liquidity, Will Act Prudently to Avoid "Taper Tantrum"

Powell expects the Fed may stop reducing its balance sheet in the coming months. In his speech, he said the Fed's long-standing plan is to stop action when reserves are slightly above the level the Fed judges to be adequate.

"We may be approaching that level in the coming months, and we are closely monitoring various indicators to inform this decision."

Powell acknowledged that there are signs liquidity is gradually tightening, but mentioned that the Fed's "plans indicate they will take prudent measures to avoid a repeat of the September 2019 money market stress." Commentators believe Powell is referring to avoiding the "taper tantrum" market volatility caused by reducing QE.

In September 2019, the U.S. short-term funding market experienced a "cash crunch," with overnight repo rates soaring to 10%. The Fed was forced to launch overnight repo operations for the first time in a decade, injecting massive liquidity into the money market. Wallstreetcn previously noted that mainstream research believes the September 2019 repo crisis was caused by a combination of tight liquidity, tax payment days, large-scale Treasury issuance, and large banks needing to reserve significant amounts of reserves due to intraday liquidity regulations.

During the Q&A session, Powell said that the indicators the Fed monitors show that bank system reserves are still "ample," but with rising repo rates, there are some signs of tightening in money market conditions.

Loss of Ability to Pay Interest on Reserves Means Loss of Rate Control, Greater Market Disruption

This year, some lawmakers have criticized and questioned the Fed's payment of interest on reserves held by commercial banks. In his speech on Tuesday, Powell defended the important reserve mechanism, saying the Fed's reserve system is very effective and works well, warning that if the Fed were deprived of the ability to pay interest on reserves, it would lose control of interest rates and cause greater market disruption. 

Commentators believe Powell's speech was clearly a response to criticism from U.S. Treasury Secretary Bessent and other Republicans, mentioning that some have questioned the Fed's purchase of MBS, some believe there should be better explanations for bond purchases, and others question whether interest should be paid on reserves. Powell recalled that perhaps the Fed should have stopped buying bonds more quickly after 2020.

On Tuesday, Powell mentioned that the Fed is considering adjusting the composition of its asset holdings, increasing its holdings of short-term assets.

Collins commented that increasing holdings of short-term debt and other short-term assets is not a new idea. Some investors believe that if the U.S. Treasury increases the issuance of short-term debt and the Fed buys a significant portion of it, it is equivalent to a form of stealth QE, because the overall weighted average interest rate of outstanding Treasuries would be lower.

But Collins pointed out that more short-term Treasury issuance does not necessarily flatten the yield curve. The main driver of the U.S. Treasury yield curve remains policy expectations, not net supply changes.

Other Indicators Cannot Replace Official Data, Asked About Gold Price Rise

During the Q&A session, Powell said that due to the government shutdown and the lack of data such as the nonfarm payroll report, everyone is looking at the same employment data—those released by the private sector. He emphasized state-level employment data and the ADP employment report, known as the "small nonfarm," but said that these data cannot replace the gold standard of official statistics.

Speaking of alternative data, Powell said some indicators can supplement official government statistics but cannot replace them. He noted that in the absence of government reports, it is especially difficult to accurately interpret prices.

When asked about the rise in gold prices, Powell said: "I will not comment on any specific asset price."

When asked about the impact of artificial intelligence (AI), Powell quoted Nobel laureate Robert Solow's famous line about how new technology will affect productivity: "You can see computers everywhere except in the productivity statistics." He added, "That may be the case here."

Powell said Fed officials keep a low profile and stay away from politics. "We don't go back and forth with anyone. That quickly becomes a political issue." The Fed's only goal is to do a good job for the public. But he added: "Don't pursue perfection. These are urgent decisions that must be made in real time."

 

Powell said the Fed would not comment on immigration policy, but noted that the Trump administration's policies in this area were tougher than many expected. He said labor force growth and the number of entrants have dropped sharply, which could lead to fewer workers. But we are only just beginning to see the effects of these policies.

Full Text of Powell's Speech

The following is the full text of Powell's speech on interpreting the Fed's balance sheet:

Interpreting the Fed's Balance Sheet

Remarks by Federal Reserve Chair Jerome H. Powell at the 67th Annual Meeting of the National Association for Business Economics in Philadelphia, Pennsylvania.

Thank you, Emily. And thank you to the National Association for Business Economics for awarding me the Adam Smith Award. I am deeply honored to join the ranks of previous recipients, including my predecessors Janet Yellen and Ben Bernanke. Thank you for your recognition and for the opportunity to speak with you today.

Monetary policy is more effective when the public understands how and why the Fed operates. With that in mind, I hope to deepen public understanding of the Fed's balance sheet, which is one of the more obscure and technical aspects of monetary policy. A colleague recently compared this topic to going to the dentist, but that analogy may not be fair to dentists.

Today, I will discuss the important role our balance sheet played during the (COVID-19) pandemic and some lessons learned. Then, I will review our ample reserves implementation framework and our progress in normalizing the size of the balance sheet. Finally, I will briefly discuss the economic outlook.

Background on the Fed's Balance Sheet

One of the central bank's main responsibilities is to provide the monetary base for the financial system and the broader economy. This base consists of the central bank's liabilities. As of October 8, the Fed's total balance sheet liabilities stood at $6.5 trillion, about 95% of which are made up of three types of assets. First is $2.4 trillion in Federal Reserve notes (i.e., physical currency). Second is $3 trillion in reserves (i.e., funds that depository institutions hold at Federal Reserve Banks). These deposits allow commercial banks to make payments and meet regulatory requirements. Reserves are the safest and most liquid assets in the financial system, and only the Fed can create them. Ample reserves are crucial for the safety and soundness of our banking system, the resilience and efficiency of our payment system, and ultimately the stability of our economy.

The third category is currently about $800 billion (balance) in the Treasury General Account (TGA), which is essentially the federal government's checking account. When the Treasury makes payments or receives funds, these flows affect the supply of reserves or other liabilities in the system dollar for dollar.

The assets on our books are almost entirely securities, including $4.2 trillion in U.S. Treasuries and $2.1 trillion in agency mortgage-backed securities (MBS). When we add reserves to the system, it is typically by buying Treasuries in the open market and crediting the reserve account of the seller's bank. This process effectively converts securities held by the public into reserves, but does not change the total amount of government liabilities held by the public.

The Balance Sheet as an Important Tool

The Fed's balance sheet is a key policy tool, especially when the policy rate is constrained by the effective lower bound (ELB). In March 2020, when the COVID-19 pandemic broke out, the economy nearly ground to a halt, financial markets broke down, and a public health crisis threatened to become a severe and lasting economic recession.

To address this, we set up a series of emergency liquidity facilities. These programs, supported by Congress and the administration, provided critical support to markets and were highly effective in restoring confidence and stability. The loans provided by these facilities peaked at just over $200 billion in July 2020. As conditions stabilized, most of these loans were quickly unwound.

Meanwhile, the U.S. Treasury market—normally the world's deepest and most liquid market and the cornerstone of the global financial system—was under enormous stress and on the verge of collapse. We restored normal functioning to the Treasury market through large-scale securities purchases. In the face of unprecedented market dysfunction, the Fed bought Treasuries and agency debt at an astonishing pace 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 the eventual economic recovery. This policy easing was crucial, as we had lowered the federal funds rate to near zero and expected it to remain there for some time.

By June 2020, we slowed the pace of asset purchases to $120 billion per month, but the scale remained significant. In December 2020, with the economic outlook still highly uncertain, the Federal Open Market Committee (FOMC) said we expected to maintain this pace of purchases "until substantial further progress has been made toward the Committee's maximum employment and price stability goals." This guidance ensured that, in the face of unprecedented circumstances, the Fed would not withdraw support prematurely while the recovery was still fragile.

We maintained the pace of asset purchases until October 2021. By then, it was clear that without strong monetary policy action, high inflation was unlikely to subside. At the November 2021 meeting, we announced a gradual tapering of asset purchases. At the subsequent December meeting, we doubled the pace of tapering and said asset purchases would end by mid-March 2022. Over the course of the program, our securities holdings increased by $4.6 trillion.

Some observers questioned the scale and composition of asset purchases during the pandemic recovery, which is understandable. Throughout 2020 and 2021, as the pandemic repeatedly erupted, causing widespread disruption and loss, the economy faced major challenges. During that turbulent period, we continued to purchase assets to avoid a sharp and unwelcome tightening of financial conditions while the economy was still highly fragile. Our thinking was influenced by events in recent years, when signals of balance sheet reduction triggered significant tightening of financial conditions. We had in mind the events of December 2018 and the "taper tantrum" of 2013.

Regarding the composition of our purchases, given the strong recovery in the housing market during the pandemic, some have questioned whether agency MBS purchases should have been included. Aside from purchases specifically for market functioning, the main purpose of buying MBS, like Treasuries, was to ease broader financial conditions when the policy rate was constrained by the ELB. During this period, it is difficult to determine the extent to which MBS purchases affected housing market conditions. Many factors influence the mortgage market, and many factors outside the mortgage market also affect the broader supply and demand in the housing market.

In hindsight, we could have—or perhaps should have—stopped asset purchases earlier. Our real-time decisions were aimed at guarding against downside risks. We knew that once purchases ended, we could unwind positions relatively quickly, and that is what we did. Research and experience tell us that asset purchase programs affect the economy through expectations of future balance sheet size and duration. When we announced a tapering of purchases, market participants began to price in its effects, bringing forward the tightening of financial conditions. Stopping purchases earlier might have made some difference, but would likely not have fundamentally changed the economic trajectory. Nevertheless, our experience since 2020 does show that we can use the balance sheet more flexibly, and as market participants become more familiar with these tools, we are more confident that our communications can help them form reasonable expectations.

Some have also argued that we could have done a better job of explaining the purpose of asset purchases in real time. There is always room for improvement in communication. But I believe our statements made our goals quite clear: to support and maintain smooth market functioning and to help foster accommodative financial conditions. Over time, the relative importance of these goals shifts with economic conditions. But these goals never conflicted, so at the time, the distinction seemed minor. Of course, that is not always the case. For example, the banking stress in March 2023 led to a sharp increase in our balance sheet through lending operations. We made it clear that these financial stability operations were separate from our monetary policy stance. In fact, we continued to raise policy rates during this period.

Our Ample Reserves Framework Works Well

Returning to my second topic, our ample reserves system has proven very effective, allowing us to control our policy rate under a range of challenging economic conditions, while promoting financial stability and supporting a resilient payment system.

Under this framework, ample reserves ensure sufficient liquidity in the banking system, and we control the policy rate by setting administered rates (the interest rate on reserve balances and the overnight reverse repo rate). This approach allows us to maintain rate control regardless of balance sheet size. This is crucial given the large and unpredictable swings in private sector liquidity demand and the significant fluctuations in autonomous factors (such as the TGA) that affect reserve supply.

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 under 22%, while maintaining effective rate control.18

Our long-standing plan is to stop reducing the balance sheet when reserves are slightly above the level we judge to be adequate. We may be approaching that level in the coming months, and we are closely monitoring various indicators to inform this decision. Some signs are beginning to show that liquidity conditions are gradually tightening, including generally stronger repo rates and more pronounced but temporary pressures on specific dates. The (FOMC) Committee's plans indicate a cautious approach to avoid a repeat of the September 2019 money market stress. In addition, tools in our implementation framework, including the standing repo facility and the discount window, will help manage funding pressures and keep the federal funds rate within the target range during the transition to lower reserve levels.

Normalizing the size of the balance sheet does not mean returning to pre-pandemic levels. In the long run, the size of our balance sheet depends on public demand for our liabilities, not our pandemic-related asset purchases. Currently, non-reserve liabilities are about $1.1 trillion higher than before the pandemic, requiring us to hold an equivalent amount of securities. Demand for reserves has also risen, partly reflecting growth in the banking system and the overall economy.

Regarding the composition of our securities portfolio, compared to outstanding U.S. Treasuries, our portfolio is currently overweight long-term securities and underweight short-term securities. The long-term composition will be a topic for Committee discussion. The transition to our desired composition will be gradual and predictable, giving market participants time to adjust and minimizing the risk of market disruption. Consistent with our long-standing guidance, our goal is to build a portfolio composed primarily of U.S. Treasuries over the long term.

Some have questioned whether the interest we pay on reserves imposes a heavy burden on taxpayers. That is not the case. The Fed's interest income comes from the U.S. Treasuries that support reserves. In most cases, the interest income we earn from holding Treasuries is sufficient to cover the interest paid on reserves, resulting in large remittances to the Treasury. By law, after paying expenses, all profits must be remitted to the Treasury. Since 2008, even including recent negative net income, our total remittances to the Treasury have exceeded $900 billion. Due to rapid rate hikes to control inflation, our net interest income is temporarily negative, but this is extremely rare. Our net income will soon turn positive again, as is common in our history. Of course, negative net income does not affect our ability to conduct monetary policy or meet our financial obligations.

If we were unable to pay interest on reserves and other liabilities, the Fed would lose control of interest rates. The stance of monetary policy would no longer be aligned with economic conditions and would push the economy away from our (full) employment and price stability goals. Restoring rate control would require large-scale, rapid sales of securities, shrinking our balance sheet and system reserves. The scale and speed of such sales could strain Treasury market functioning and harm financial stability. Market participants would have to absorb the sales of Treasuries and agency MBS, putting upward pressure on the entire yield curve and raising borrowing costs for the Treasury and the private sector. Even after weathering this turmoil and disruption, the resilience of the banking system would be reduced, making it more vulnerable to liquidity shocks.

Most importantly, our ample reserves system has proven very effective in implementing monetary policy and supporting economic and financial stability.

Current Economic Conditions and Monetary Policy Outlook

Finally, I will briefly discuss the economic and monetary policy outlook. While some key government data releases have been delayed due to the government shutdown, we regularly assess a range of still-available public and private sector data. We also have a nationwide network of contacts established through the (regional) Feds, who provide valuable insights that will be summarized in tomorrow's (Fed) Beige Book.

Based on the data we have, it is fair to say that since our September meeting four weeks ago, the outlook for employment and inflation appears to have changed little. Data obtained before the government shutdown show that the trajectory of economic activity may be more robust than expected.

While the unemployment rate remained low in August, wage growth slowed significantly, possibly partly due to reduced immigration and a declining labor force participation rate leading to slower labor force growth. In this lackluster and somewhat weak labor market, downside risks to employment seem to have increased. Although the official September employment data was delayed, existing evidence suggests that both layoffs and hiring remain low, and both household perceptions of available jobs and business perceptions of hiring difficulty continue to decline.

Meanwhile, over the 12 months ending in August, core personal consumption expenditures (PCE) inflation was 2.9%, slightly higher than at the start of the year, as rising core goods inflation outweighed the continued decline in housing services inflation. Current data and surveys continue to indicate that the rise in goods prices mainly reflects tariffs, rather than broader inflationary pressures. Consistent with these effects, short-term inflation expectations have generally risen this year, while most long-term inflation expectation indicators remain aligned with our 2% target.

The increased downside risk to employment has changed our risk balance assessment. Therefore, we considered it more appropriate to take a more neutral policy stance at the September meeting. As we strive to address the tension between our employment and inflation goals, there is no risk-free policy path. This challenge is evident in the range of projections by Committee members at the September meeting. I want to emphasize again that these projections should be understood as a range of possible outcomes, with probabilities changing as new information affects our decisions at each meeting. We will set policy based on the evolution of the economic outlook and risk balance, not by following a predetermined path.