Panel remarks prepared for the “Monetary Policy and Financial Stability Challenges during Balance Sheet Normalization” session, Federal Reserve Bank of Atlanta 2022 Financial Markets Conference, Amelia Island, Florida, May 10, 2022, 3:00 p.m. ET
Good afternoon. I would like to thank Raphaël Bostic for inviting me to take part in this panel devoted to the normalization of balance sheets. I have had the opportunity to attend and participate in this conference over the past few years, and it has never disappointed in bringing together interesting research and interesting policy insights. This year’s conference is no exception.
In my brief prepared remarks, I will describe how the FOMC intends to significantly reduce the holdings of securities on its balance sheet. The views I present today will be my own and not necessarily those of the Federal Reserve or my colleagues on the Federal Open Market Committee.
Throughout the pandemic, in addition to the federal funds rate, the Fed has used its balance sheet as a policy tool, buying large volumes of Treasuries and agency mortgage-backed securities. With nearly $9 trillion in assets, the Fed’s balance sheet is now about double what it was before the pandemic. These asset purchases were an important policy response to the severe financial market stress seen at the start of the pandemic, and throughout the pandemic they have helped support the economy amid the unprecedented COVID shock. Markets are functioning now, a solid expansion is underway, and inflation is well above the Fed’s long-term 2% target. So, at its May meeting last week, the FOMC decided that it would start reducing the size of its balance sheet in June. To lay the groundwork and help prepare financial markets for this announcement, the FOMC, after its January meeting, issued a set of guiding principles for the cut, and the Committee gave more details of its plans in the lawsuit. minutes of its March meeting. The plans announced last week are consistent with previous communications.
The reduction in the balance sheet will occur in a predictable manner, primarily by adjusting the reinvestment amounts of principal payments the Fed receives on its assets. Starting in June, the Fed will allow up to $30 billion a month of Treasury securities and up to $17.5 billion of agency securities to come off the balance sheet. After three months, those caps will increase to $60 billion per month for treasury bills and $35 billion per month for agency securities. To the extent that maturing treasury bills are below the monthly cap, treasury bills will make up the remainder of the runoff up to the cap.
The plan builds on our experience from October 2017 to August 2019, when the FOMC wrote down some of the assets that had been purchased following the Great Recession. But there are important differences. Last time, the liquidation caps were initially set at $6 billion per month for treasury bills and $4 billion per month for agency securities, and the implementation was very gradual, with caps increasing by $6 billion and $4 billion, respectively, every 3 months during the period. over the next 12 months, to $30 billion for treasury bills and $20 billion for agency securities. This time the setup is only 3 months and the monthly trickle caps total $95 billion, almost double from last time. Another difference is that the last time the balance sheet reduction began nearly two years after the funds rate took off from zero; this time it begins about 2.5 months after takeoff. I do note, however, that even though the gap between take-off and the start of the balance sheet reduction is much shorter this time, the target range level is not that different – only 25 basis points lower this time – because the funds rate increased very slowly last time.1
These differences reflect the fact that the economy is in a very different situation today than it was then. When the Fed began cuts in October 2017, balance sheet assets had shrunk to around $4.5 trillion, or 22% of GDP; reserves were about $2.2 trillion, or 11% of GDP; the unemployment rate was about 4-1/4 percent; real output growth was close to 2.7%; and inflation was still slightly below 2%. Today, balance sheet assets stand at around $9 trillion, or 37% of GDP; reserves averaged about $3.8 trillion, or about 15% of GDP; labor markets are very tight, with an unemployment rate of 3.6%; the economy grew by 5.5% last year; and instead of being below our target, PCE inflation is currently at 6.6%, a 40-year high.
Let me end by addressing two issues that the plan announced last week did not address: asset sales and the size of the balance sheet when the cuts end.
The plan did not exclude the sale of assets. The FOMC did not discuss sales, but minutes from the March meeting indicated that FOMC participants generally agreed that once balance sheet reduction is well under way, it would be appropriate to consider sales of agency mortgage-backed securities. An important benefit of the sales is that they would help accelerate the return of our portfolio composition to primarily Treasuries, consistent with the FOMC’s stated desire to minimize the effect of Fed balance sheet holdings on allocation. credit between economic sectors. A potential way to implement the sales would be to sell agency securities up to the cap in any month in which principal payments were below the cap. This is similar to our treatment of treasury bills. Another way to implement sales would be to set a monthly floor on reductions, which would be covered first by principal payments received, then by sales. A potential downside of the selloffs is that, depending on the path of interest rates, they could result in realized mark-to-market losses, which would reduce Fed rebates to the Treasury. Such losses would pose no operational challenge for the Fed in setting monetary policy. However, they would pose communication issues that would need to be addressed appropriately so that the public understands the benefits of returning the balance sheet to a more normal size and composition despite the losses.
Second, the plan did not indicate the size of the balance sheet when the FOMC ends the cuts, but it did give some guidance. We implement monetary policy through an abundant reserve tapping regime in which reserve levels are large enough to control the federal funds rate and other short-term interest rates. primarily by setting Fed-administered rates and actively managing the supply of reserves. no need. The FOMC intends to slow and then halt the decline in balance sheet assets when reserve balances are somewhat above the level it deems consistent with ample reserves. Once the trickle stops, reserve balances will likely continue to decline for some time, mirroring growth in other Fed liabilities, until the FOMC deems they have reached the sufficient level. At this point, the FOMC will then manage its securities holdings to maintain sufficient reserves over time. The sufficiency of reserves is uncertain. This will depend on the banking sector’s demand for reserves, as well as the distribution of this demand among institutions, which will change over time. During the last episode of reduction, the FOMC ended the runoff when reserve levels were around $1.5 trillion, or 7% of GDP. When tensions developed in short-term money markets in mid-September 2019, the FOMC estimated that the level of reserves had fallen below the level consistent with abundant reserves, and in October 2019 the FOMC began to buy treasury bills and make term and overnight redemptions. operations of the agreement to maintain reserve balances at or above the level that prevailed at the beginning of September 2019.
This time, as the process of reducing the size of the balance sheet progresses, we will again monitor the evolution of the money markets in order to determine the appropriate level of reserves at which to end the liquidation of the balance sheet, in accordance with the maintenance of balances of sufficient reserves over time. .
This was a brief summary of the FOMC’s plan to significantly reduce assets on the Federal Reserve’s balance sheet. I look forward to hearing feedback from other panelists and participating in the discussion.