Fed's Powell Suggests Outsized Balance Sheet Is Here to Stay

(Bloomberg) -- An elevated Federal Reserve balance sheet is looking like it’s here to stay.

Fed Governor Jerome Powell said on Thursday that the central bank probably won’t reduce its $4.5 trillion balance by more than $2 trillion over the next five years as it normalizes monetary policy.

“It’s hard to see the balance sheet getting below a range of $2.5-$3 trillion,” Powell told the Economic Club of New York in remarks that also called for the central bank to continue gradual interest rate increases.

A balance sheet of that size is well above the roughly $1 trillion that prevailed before the 2008-09 financial crisis. It’s about in line though with the $3.1 trillion level primary dealers predicted it would reach at the end of 2025 in a survey by the New York Fed conducted in April.

How far the Fed shrinks its balance sheet has big implications for financial markets and the economy. The central bank owns $2.5 trillion of Treasury debt and $1.8 trillion of mortgage-backed securities. A sizable drop in those holdings could drive up long-term borrowing costs, hurting the housing market and crimping economic growth in the process.

The Federal Open Market Committee is slated to discuss its balance sheet strategy when it meets on June 13-14 in Washington. The panel is also widely expected to lift its target range for short-term rates for the second time this year.

Powell said the Fed won’t decide how big the balance sheet eventually should be until after it begins the draw-down process, which he expects will be later this year.

“We have not made a decision about the long-run framework, and we are not going to make one before the beginning of the normalization process,” he said.

The ultimate size of the balance sheet was tied up in the issue of how the Fed conducts monetary policy, he said.

Corridor or Floor

If it returns to the method it used before the crisis, the balance sheet could be much smaller than otherwise, he said. That’s because that “corridor” technique was predicated on keeping the reserves that commercial banks hold at the Fed to a minimum.

Under the system now employed by the Fed, “reserves have to be abundant,” Powell said. The current “floor” methodology hinges on the Fed’s ability to pay interest on those reserves.

The “corridor framework remains a feasible option, although, in my view, it may be less robust over time than a floor system,” the Fed governor said.

Investors’ muted reaction so far to the Fed’s evolving balance sheet plan indicates that the start of the draw-down will not overly disrupt financial markets, according to Powell.

“The market’s response to recent changes in expectations for reinvestment policy also suggests that there need not be a major reaction when the Committee begins to phase out reinvestments,” he said.

However, if the asset run-off tightens financial conditions more than expected, “the FOMC would take that into account,” he said.

In a separate interview with CNBC television, he said he could see the Fed raising rates “a couple of more times” this year if the economy performs as policy makers expect.

Inflation Watch

He told the Economic Club that in particular he would be closely monitoring how inflation develops.

“It is important that the Committee assess incoming inflation data carefully and continue to demonstrate a strong commitment to achieving our symmetric 2 percent objective,” Powell said.

Powell, who has been in office since 2012, is a centrist when it comes to monetary policy. His comments are in line with what colleagues including Governor Lael Brainard and Dallas Fed President Robert Kaplan have said this week: Economic momentum is holding up, but a recent dip in inflation away from the Fed’s 2 percent goal bears watching as the year progresses.

--With assistance from Jeanna Smialek and Catarina Saraiva

To contact the reporters on this story: Rich Miller in Washington at rmiller28@bloomberg.net, Matthew Boesler in New York at mboesler1@bloomberg.net.

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Alister Bull