Fed Balance Sheet in Focus

As expected, the Federal Reserve held its policy rate range steady at the January meeting, and the statement changed only modestly from December. In his press conference, Fed Chair Jerome Powell said that the Federal Open Market Committee (FOMC) still expects the U.S. economy to expand at a moderate pace, and reiterated the FOMC’s prior guidance that rates will remain on hold. More importantly, in light of still below-target inflation, he also emphasized the asymmetric nature of the inflation target and alluded that the FOMC would tolerate a period of above-target inflation if it were to occur, to ensure that inflation expectations remain well anchored at (not below) the inflation target.

After Wednesday’s statement and press conference, our base case outlook for the policy rate aligns with the Fed’s view. However, given our forecast for U.S. growth to slow somewhat more in the first half of 2020, and inflation to remain below target, we continue to see a lower bar to cutting rates relative to hiking.

Perhaps the more interesting takeaway was Powell’s guidance on the balance sheet. He stated that the FOMC is targeting a level of financial system reserves no lower than $1.5 trillion to fulfill its commitment to operating monetary policy in an ample reserve regime. Taking a step back, since the period of notable money market stress in mid-September 2019, the Fed has been doing technical operations, including temporary lending through repo auctions and outright purchases of Treasury bills, in an effort to increase bank reserves, calm money markets, and ensure the effective fed funds rate (EFFR) remains within the target range. In our view, these programs have been effective at their stated goals. As such, it’s natural that the Fed would wind them down. We think the Fed will pare down its current operations, leaving the average level of reserves around $1.55 trillion to $1.60 trillion while not allowing them to dip below $1.5 trillion.