quora Fed to Expand Balance Sheet 'Soon' to Respond to Funding Issues
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Fed to Expand Balance Sheet ‘Soon’ to Respond to Funding Issues

The Federal Reserve: The Federal Reserve will start growing its balance sheet soon. Its Chairman Jerome Powell said on Tuesday. He was responding partly to the blow on overnight lending markets in September.

The Fed will explain how it will expand the securities it holds in the coming days. Though it will involve treasury bill purchases, Powell stressed that the approach shouldn’t be confused with quantitative easing done during and after a financial crisis. He commented during his speech in Denver.

Broadly, on monetary policy, Powel and his fellow policymakers stuck to their view of the economy is strong. However, the economy was prone to shocks from trade, global slowdown, and geopolitics, just like the potentially messy Brexit.

He said the Federal Reserve was committed to supporting the recovery but is depends on data –  not on a preset way of cutting rates.

The Fed Reserve has cut its benchmark rate twice in 2019 and expected to approve the third cut later this month.

Stocks trimmed some of their losses as Powel spoke, and short-term Treasury yields hit their lows of the day.

Time for the Fed to expand balance sheet ‘is now upon us.’

Onto the balance sheet. Overnight repurchase markets failed in several weeks ago, partly because of funding constraints. Companies sucked money out of the system to make tax payments and treasury Department settling bond auctions –  causing funding constraints.

Funding limits caused repo rates to shoot as high as 10% and Fed’s benchmark funds rate to go above its 5 basis points. Fed’s benchmark funds rate is a rate which banks charge each other for short-term borrowing.

Subsequently, the Federal Reserve has been conducting temporary operations to provide cash in exchange for ultra-safe assets.

However, Powell said the Federal Reserve would embark on more permanent operations to ensure the system has enough reserves and to control market volatility events.

He added that volatility would hinder effective implementation of monetary policy and that they were addressing it. He said they would announce measures to add to the supply of reserves over time.

Fed officials have been thinking about proper reserve levels to keep in the system. Bank’s cash level at the Fed has dropped to about $1.5 trillion from a peak of $2.8 trillion in September 2014.

Three cycles of quantitative easing or asset purchases took the balance sheet to as high as $4.5 trillion. The rise was before the Fed started allowing proceeds to roll off each month.

However, President Trump sharply criticized the move, equating balance sheet reduction to quantitative tightening. He charged that to slowing economic growth.

But Powell maintained that the Fed was settling into ample reserves regime. He sees that now the reserves are at a level banks need. Earlier in a March statement on balance sheet normalization, the Fed indicated that they would increase their securities holdings to maintain appropriate reserve levels.

“That time is now upon us,” Powel said.

While Powell did not specify how the Fed would proceed, he quickly drew one line – that the program should not be mistaken for the three cycles of Qualitative Easing. Qualitative Easing is an aggressive effort to expand the balance sheet.

Instead, it will be a more organic process similar to what the Fed carried out before the 2008 financial crisis.

Powell’s dissertation on “profound changes in the economy”

Interest rate policy and balance sheet approach came after Powell’s dissertation on economic changes, and the challenges they present to the current conditions.

Powell broke the challenges into three questions:

  1. How gas price spike might affect the economy
  2. Whether productivity is measured adequately
  3. Whether the labor market is tight

In his dissertation, Powell said a spike in gas prices could be absorbed and would likely have little impact. He added that current productivity measures are likely inadequate because of technological factors. And, that jobs are expected to grow more slowly than the data indicate, though still expanding fast enough to absorb new players to the labor force.

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