Esther George, Speech: Constraints on the Economy and Policy
“We will have to determine the course of our policy through observation rather than reference to theoretical models or pre-pandemic trends. Given the likely lags in the passthrough of tighter monetary policy to real economic conditions, this argues for steadiness and purposefulness over speed.”
“The path of policy is also likely to influence plans to shrink the Federal Reserve’s elevated balance sheet. The economy is in unfamiliar territory, with a combination of high inflation and tight labor markets not seen in decades. Markets are understandably volatile as they grapple with the many unknowns surrounding the outlook for the economy. Limiting the extent to which uncertainty about the pace of interest rate adjustments contributes to this volatility could be important as balance sheet runoff hits its stride.”
“Successfully shrinking the balance sheet will lessen the Federal Reserve’s footprint in financial markets. In particular, the large balance sheet is distorting the price of duration and artificially flattening the yield curve in a way that could promote a reach for yield by investors with potential implications for financial stability.”
“Despite plans announced last May to significantly reduce the size of the balance sheet, the potential exists that there is an asymmetry that allows for relatively easy increases in the balance sheet but makes subsequent decreases more difficult. In a paper presented at this year’s Jackson Hole Symposium, the authors argue that financial markets can become dependent on the increased liquidity added to the system as the balance sheet expands. After markets have adapted and allocated the massive increase in liquidity from asset purchases, subsequently reducing the balance sheet can be difficult. As a result, large reductions in liquidity, especially absent a signal on longer-run objectives for the balance sheet, can result in volatility, like we witnessed in September 2019. One implication is that a clear signal to financial markets that an expanded balance sheet is temporary and not meant to be permanent could dampen volatility and ease the drawdown in liquidity in the longer run.”
“Having committed to operating in an ample reserves regime, what constitutes “ample” can evolve over time and will be dependent on the decisions of financial market participants.”
“There may be benefits to announcing the desired reserve levels as the balance sheet shrinks, giving banks time to prepare to operate with significantly fewer reserves.”