– Officials Also Continued to Advocate Cautious Approach to Rate Cutting
By Steven K. Beckner
(MaceNews) – With near unanimity, Federal Reserve officials have taken a cautious, gradual, “risk management” oriented approach to an eventual reduction of short-term interest rates, and Friday some outlined a similar viewpoint on the quantitative side of monetary policy. Neither Fed Governor Christopher Waller nor Dallas Federal Reserve Bank President Lorie Logan showed any eagerness to dial back the pace at which the Fed is shrinking its securities portfolio.
The Fed has been shrinking its balance sheet by $95 billion per month by not reinvesting proceeds of maturing Treasury and agency mortgage-backed securities, but Fed Chair Jerome Powell said after the Jan. 30-31 Federal Open Market Committee meeting that the policymaking FOMC would begin discussing changes in its balance sheet strategy at its March 19-20 meeting.
Waller said the Fed “can continue to reduce our holdings for some time” and said the decision as to when to slow run-offs of securities or “quantitative tightening’ should be made independent of the decision to start lowering the federal funds rate.
Logan, who knows more than most about the Fed balance sheet after running the New York Fed’s open market trading desk, said the Fed should take a slow, gradual approach to balance sheet “normalization.”
She said the Fed should “feel its way” in determining how quickly or slowly to curb run-off.
Meanwhile, Fed officials have given few indications in recent days they are ready to lower short-term interest rates in the near future. They spoke of an eventual desire to make policy less restrictive but evinced little eagerness to cut rates and made clear that any rate cuts must hinge on demonstrated progress in bringing inflation down to the Fed’s 2% target.
That perspective seemed to be little changed by the Commerce Department’s Thursday morning report that its price index for personal consumption expenditures (PCE) — the Fed’s preferred inflation gauge – rose 0.3% in January or 2.4% from a year earlier. The more closely watched core PCE was up 0.4% for the month and 2.8% year-over-year.
After the report, Cleveland Fed President Loretta Mester, an FOMC voter, said the PCE report showed there is “a little more work for the Fed to do here in terms of making sure that we can get all the way back to that 2% goal.” But she said it “doesn’t really change my view” that the three 25 basis point rate cuts projected by FOMC participants in December still “feels about right to me.”
Atlanta Fed President Raphael Bostic, another FOMC voter, continued to say it will likely be appropriate to start cutting interest rates some time “this summer.”
Chicago Fed President Austan Goolsbee again talked about the economy being on “a golden path” to lower inflation (albeit not all the way to 2%) and continued strong economic growth and labor markets. He had previously said that scenario should allow for the three 25 bp projected rate cuts at some point and has warned against waiting too long to start cutting rates.
All of Friday’s Fed speakers voted at the end of January to leave the funds rate in a target range of 5.25% to 5.50% for a fifth straight FOMC meeting. However, they dropped a long-standing tightening bias in favor of more neutral policy guidance in preparation for the 75 basis points of rate cuts projected in December.
Powell told reporters on Jan. 31 the funds rate was “likely at its peak for this tightening cycle and that, if the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year.” But he said “the Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%.”
Earlier this week, New York Federal Reserve Bank President John Williams sent a strong signal that he is far from ready to start easing policy. “While the economy has come a long way toward achieving better balance and reaching our 2% inflation goal, we are not there yet.”
“We still have a ways to go on the journey to sustained 2% inflation,” said the FOMC Vice Chairman, who had previously said rate cuts will not be appropriate until “later this year.”
Hawkish Fed Governor Michelle Bowman said, “Should the incoming data continue to indicate that inflation is moving sustainably toward our 2% goal, it will eventually become appropriate to gradually lower our policy rate to prevent monetary policy from becoming overly restrictive.” But she added, “we are not yet at that point.”
“Reducing our policy rate too soon could result in requiring further future policy rate increases to return inflation to 2% in the longer run….,” she warned.
Bowman called monetary policy “restrictive” and “appropriately calibrated to reduce inflationary pressures,” but saw “a number of upside inflation risks.” Among other things, she saw a “risk that a loosening in financial conditions and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate”
What’s more, she cited “a risk that continued labor market tightness could lead to persistently high core services inflation …. Recent labor market data suggest ongoing elevated wage growth…”
So Bowman vowed to “remain cautious in my approach to considering future changes in the stance of policy ….. I remain willing to raise the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed…..”
Kansas City Fed President Jeffrey Schmid also sounded wary of easing. “With inflation running above target, labor markets tight, and demand showing considerable momentum, my own view is that there is no need to preemptively adjust the stance of policy. Instead, I believe that the best course of action is to be patient, continue to watch how the economy responds to the policy tightening that has occurred, and wait for convincing evidence that the inflation fight has been won …..”
Describing what she needs to see to support rate cuts, non-voting Boston Fed chief Susan Collins said, “it will be important to see sustained, broadening signs of progress toward the Fed’s dual mandate goals – while recognizing that progress may be uneven….”
“I want to see more evidence of a sustained trajectory to price stability,” she said. “Still, consistent with projections from FOMC participants, I believe it will likely become appropriate to begin easing policy later this year. When this happens, a methodical, forward-looking approach to reducing rates gradually should provide the necessary flexibility to manage risks, while promoting stable prices and maximum employment.”
The Logan and Waller comments on the balance sheet Friday came in reaction to a paper on quantitative tightening presented at the University of Chicago Booth School of Business’s annual Monetary Policy Forum.
In her presentation, Logan advocated a slow, gradual approach to balance sheet “normalization” and said the Fed should “feel its way” in determining how quickly or slowly to curb run-off.
She began by focusing on the spread between money market rates and the interest rate on reserve balances (IORB) and said, “the ample level of reserves is one where spreads of money market rates to IORB are generally small.” She said the Fed needs to aim for the most efficient spread between money market rates and interest on reserve balances.
“When money market spreads to IORB are small, banks will avoid economizing excessively on reserves and taking inappropriate liquidity risk,” Logan said. “By contrast, when reserves are below ample and money market rates are meaningfully above IORB, banks face an implicit tax on liquidity. This can make the financial system less safe and less efficient. More-than-ample reserve levels are also inefficient.”
Currently, she noted, “money market rates are running as much as 10 basis points below IORB, tilting the liquidity playing field away from non-banks that can’t hold reserves.”
Logan argued that the time to “normalize” the balance sheet is drawing nearer, but is still not upon the FOMC.
“While it was necessary and appropriate to temporarily expand the Fed’s balance sheet in response to the economic and financial stresses of the pandemic, it’s important to normalize the balance sheet and remove these inefficiencies now that the stresses have passed….,” she said, but she declined to specify what she thinks the appropriate “ample” level of reserves is.
“Banks’ demand for reserves varies significantly over time as the economy and financial system evolve,” she observed. “For example, the liquidity stresses last March inspired many banks to reevaluate how they manage reserves, and supervisory or regulatory developments could lead to further changes in reserve demand.”
“So, I don’t think we can identify the ample level in advance,” Logan said. “We’ll need to feel our way to it by observing money market spreads and volatility.”
“To me, the need to feel our way means that when ON RRP balances approach a low level, it will be appropriate to slow the pace of asset runoff,” she continued. “As long as there are significant balances in the ON RRP facility, we can be confident that liquidity is more than ample in the aggregate.”
But Logan added, “once the ON RRP is empty, there will be more uncertainty about how much excess liquidity remains. Moreover, the current pace of runoff is about twice what it was in the first half of 2019. This hasn’t yet reduced reserves because funds have come out of the ON RRP facility instead.”
“After the ON RRP is drained, asset runoff will reduce reserves 1-for-1, all else equal.” she said. “In this environment, moving more slowly can reduce the risk of an accident that would require us to stop too soon.”
Logan said “slower runoff….is a way to approach the ample point more gradually, allowing banks to redistribute funds and the FOMC to carefully judge when we have gone far enough. This strategy will mitigate the risk of undesired liquidity stresses from QT.”
She emphasized that “slowing, to me, doesn’t mean stopping. In fact, I believe that proceeding more gradually may allow the Fed to eventually get to a smaller balance sheet by providing banks with more time to adjust …. (T)he eventual stopping point should depend on what we observe in money market volatility and spreads.”
Logan also emphasized that “ample reserves doesn’t mean eliminating all rate volatility or collapsing all money market spreads to precisely zero. Money markets and their participants are real-world institutions, not a theoretical ideal. It’s not the role of monetary policy to eliminate the various small frictions that arise in reality, and I expect we’ll continue to see minor spreads and rate fluctuations even when we operate with ample reserves in the long run.”
She added that “while the ample level of reserves is unknown, I see considerably less uncertainty about the appropriate long-run level of ON RRP balances in the ample-reserves regime.”
Waller, speaking at the same conference, also weighed in on the pace at which QT should be slowed on its way to “reducing the size of the balance sheet but retaining enough assets to manage monetary policy using an ample-reserves regime”
“As the Federal Reserve continues its QT program, I support further thinking about how many more securities to redeem,” he said. “We have an overnight reverse repurchase agreement facility with take-up of more than $500 billion, and I view these funds as excess liquidity that financial market participants do not want, so this tells me that we can continue to reduce our holdings for some time.”
Waller observed that the Fed now has a standing repurchase agreement facility (SRF), which serves as a backstop in money markets, since it takes in Treasury securities as well as agency MBS and puts reserves in the banking system.