Fed: The January Balance Sheet Debate

Published on January 25, 2019

Market attention on next week’s meeting of the Federal Open Market Committee and what Chairman Jerome Powell may or may not say in the first 2019 meeting press conference about the balance sheet got a boost this morning following a media report the FOMC is leaning towards a larger portfolio of securities compared to the indications a few years ago. 

** The size of the Fed’s securities portfolio will indeed certainly be “larger” than the initial indications around the time of the most recent revision to the Balance Sheet Normalization Principles and Plans in June 2017. For one, judging by the December meeting Minutes and a range of public comment, there does seem to be a growing view within the Committee favoring the merits of a more plentiful, pre-emptive level of reserves to lubricate the financial system.

** We also have a sense that, after the December meeting when Chairman Powell was caught off guard by the depth of market sentiment on the balance sheet policy and general market liquidity, the FOMC is seeking to “accelerate” their decision on the optimal level of reserves to be left in the banking system and what sort of operating framework they will eventually adopt (see SGH 1/9/19, “Fed: Eyes Wide Open”). 

** If for any other reason, the FOMC will need to move forward with at least a revised “Principles and Plans” statement to deflect any potential signaling or cross-purpose messaging problem in the highly likely “patient pause” on rates in the coming months. That could also become problematic if another technical adjustment in the Interest on Excess Reserves is needed to better keep the effective fed funds rate within the target range.

** We doubt, however that Chairman Powell will be able to offer anything too specific just yet on the balance sheet deliberations other than the broadest possible signposting of the progress to their discussions. If they are indeed further along than we expect and Powell is able to signal a change in the pace or terminal point to the asset run-off, we would be immensely impressed. We still think the March meeting would be the more likely earliest point for a balance sheet policy consensus to be reached that would allow for the revised Principles and Plans. 

** Powell is also likely to use the January presser to firmly maintain the distinction between the current balance sheet policy, which is more of a technical issue at this point, and the federal funds target range as the primary policy tool to provide or withdraw monetary stimulus. If the Committee concludes the gradual asset run-off is adding more to a tightening in financial conditions than assumed, the policy response will be through rates, not an adjustment in the balance sheet. 

** The balance sheet policy “normalization” is assumed to be having some tightening effect alongside the rate increases, but by how much is still uncertain and will only become a bit clearer as more of the reserves are extinguished. Indeed, as we wrote last summer (see SGH 7/27/18, “Fed: The Balance Sheet”), the balance sheet effects were one of the uncertainties going into last fall that underscored Powell’s emphasis on a shift to a data-dependent policy flexibility.

** And if asked — and he will be — Powell will stress that the decision on the eventual terminal level of reserves will be solely made on the optimal level of reserves needed “to implement monetary policy most efficiently and effectively.”

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