Upcoming Events
Monday, March 4
Divisia Release
Harker Speaks at American Council on Education Presidents and Chancellors Summit
Tuesday, March 5
Barr Speaks at National Interagency Community Reinvestment Conference
Wednesday, March 6
GDPNow Update
JOLTS Release
Powell Testifies before U.S. House Financial Services Committee
Daly Speaks at National Interagency Community Reinvestment Conference
Thursday, March 7
GDPNow Update
Powell Testifies before U.S. Senate Committee on Banking, Housing, and Urban Affairs
Mester Speaks at European Economics and Financial Centre
Friday, March 8
Jobs Report Release
Williams Speaks at London School of Economics
Saturday, March 9
FOMC Blackout Period Begins
Recent News
Inflation ticks up… The Personal Consumption Expenditures Price Index (PCEPI) grew at a continuously compounding annual rate of 4.1 percent in January 2024, according to the latest release from the Bureau of Economic Analysis (BEA). The PCEPI has grown at an annualized rate of 1.8 percent over the last three months and 2.5 percent over the last six months.
Core PCEPI, which excludes volatile food and energy prices grew at a continuously compounding annual rate of 5.0 percent in January. It has grown at an annualized rate of 2.6 percent over the last three months and 2.5 percent over the last six months.
Insufficient seasonal adjustments are likely to blame for the outsized increase in prices, much as they were last year. In January 2023, the PCEPI grew at a continuously compounding annual rate of 6.7 percent. It had grown at an annualized rate of 3.5 percent over the prior three months and would grow at an annualized rate of 3.0 percent over the subsequent three months. In hindsight, January 2023 was an outlier. January 2024 looks likely to be an outlier, as well.
Production… The BEA now says real Gross Domestic Product (GDP) grew an annual rate of 3.2 percent in Q4-2023, compared with 3.3 percent in the initial estimate. The revised estimate reflects less-than-initially-estimated private inventory investment, which was partially offset by greater-than-initially-estimated state and local government spending and consumer spending. Real GDP grew at a 4.9 percent annualized rate in Q4-2023.
The Atlanta Fed’s GDPNow model estimates real GDP will grow at an annualized rate of 2.1 percent in Q1-2024, down from 3.0 at the end of February. The model will update again on Wednesday when wholesale trade data is released.
Quantitative tightening… Fed officials are expected to begin "in-depth discussions of balance sheet issues" at its Federal Open Market Committee (FOMC) meeting later this month. The Fed’s balance sheet ballooned from around $4.1 trillion at the start of 2020 to nearly $9.0 trillion in April 2022. The Fed has since allowed around $1.4 trillion to roll off.
The question now: when should the Fed stop shrinking its balance sheet? Some Fed officials are already weighing in.
“The challenge today is knowing how far to go in normalizing the balance sheet,” Dallas Fed President Lorie Logan said last week.
In 2019, the FOMC decided that it would operate in the long run with a version of the floor system where reserves are “ample.” The word “ample” suggests comfortably but efficiently meeting banks’ demand. As I’ve argued elsewhere, the Friedman rule provides a guide to the efficient supply of reserves in the ample-reserves regime. Banks’ opportunity cost of holding reserves should be approximately equal to the central bank’s cost of supplying reserves.
Most analysts view the cost of supplying reserves as small. So, since banks’ opportunity cost of holding reserves is the spread between money market rates and the interest rate on reserve balances (IORB), the ample level of reserves is one where spreads of money market rates to IORB are generally small. […]
When money market spreads to IORB are small, banks will avoid economizing excessively on reserves and taking inappropriate liquidity risk. 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, for example, money market rates are running as much as 10 basis points below IORB, tilting the liquidity playing field away from nonbanks that can’t hold reserves. 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.
Governor Christopher Waller noted the importance of the Fed’s new 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,” and “may allow banks to lower the level of reserves below what reserves would be without the facility.” He also thinks that the SRF “may provide a signal for when reserves are getting close to ample” and that balance sheet questions can be divorced from the Fed’s interest rate policy:
Changing our pace of redemptions will occur when the Committee makes a decision to do so, and the timing will be independent of any changes to the policy rate target. Balance sheet plans are about getting liquidity levels right and approaching "ample" at the correct speed. They do not imply anything about the stance of interest rate policy, which is focused on influencing the macroeconomy and achieving our dual mandate.
Waller “would like to see the Fed's agency MBS holdings go to zero” and “a shift in Treasury holdings toward a larger share of shorter-dated Treasury securities.”
Whereas both Logan and Waller prefer the Fed maintain its ample reserves (or, floor) system, at least one FOMC member seems interested in shrinking the balance sheet even further and returning to a corridor system.
Newly-appointed Kansas City Fed President Jeff Schmid said he wants to “minimize the Fed’s footprint in the financial system, particularly as it relates to the Fed’s balance sheet.”
Decisive actions are appropriate and necessary when stresses threaten the health of the financial system and the economy. In this regard, the Fed’s ability to stabilize markets and the economy with its balance sheet is an important policy tool. However, maintaining a persistently large presence in markets in normal times comes with costs and increases the possibility of unintended consequences. These concerns have been highlighted by the Kansas City Fed in the past and are concerns I also share.
Schmid offered three reasons why the Fed should ditch its large balance sheet:
It can misallocate credit and “ultimately sow the seeds of future imbalances in the economy.”
It can alter the structure of the financial system by challenging “the ability of banks to borrow short and lend long.”
It “can give the uncomfortable impression that monetary and fiscal policy are intertwined,” which has “the potential to threaten the Fed’s independence.”
For these reasons, Schmid believes that, “once a crisis has passed, it should be a priority for the Fed to reduce its balance sheet and to lessen its footprint in financial markets.”