Week of September 9, 2024
Post-Jackson Hole and now post-jobs report, the markets can settle in for a rate cut at next week’s FOMC meeting. For the record, this easing move would represent the first non-COVID-19-related rate cut since October 2019. While all of the attention is obviously centered on what the new Fed Funds trading range will ultimately be, flying under the radar has been another key monetary policy tool: the Fed’s balance sheet.
Minds on the Markets has discussed the Fed’s balance sheet in the past, so we don’t necessarily need to do a refresher course. However, for point of emphasis, we are not referring to the entire policy maker’s balance sheet but only the portion that includes the Fed’s holdings of Treasury, agency mortgage-backed securities (MBS) and agency securities, also known as the System Open Market Account, or SOMA. In fact, if you dig a little deeper, the agency securities portion of SOMA hasn’t been a factor for quite some time, so we’re really just referring to Treasuries and MBS holdings.
Interestingly, while rate cut talk is all the rage in the markets, Powell & Co. has still been embarking on a quantitative tightening (QT) policy. Yes, the pace of QT was reduced in June, but the balance sheet runoff remains at a moderate clip of $60 billion per month.
To provide some perspective, since QT began in June 2022, the Fed has reduced SOMA by $1.8 trillion. However, its holdings are still an eye-opening $6.7 trillion, or roughly $3.0 trillion above pre-COVID-19 levels. The Fed has repeatedly stated that its preference is to ultimately have a balance sheet of only Treasuries. But the dollar amount of MBS remains rather high at $2.3 trillion, so this process will more than likely take years to work its way through.
So, with a rate cut on the immediate horizon, it has become increasingly apparent that QT will still be a part of the Fed’s monetary policy at the same time. For the record, we have never been a proponent of the viewpoint that the Fed could only cut rates if it ends QT. But how long can this type of policy divergence continue?
As yet, the policy maker has not offered any definitive intimation of when QT could come to an end. Obviously, future FOMC meetings should be considered “live” on this front as well. In other words, besides announcing changes in the Fed Funds trading range, investors should also be looking for any changes in the policy statement regarding its balance sheet. At this point, it seems reasonable the Fed will continue QT through year-end and perhaps end balance sheet runoff as we move into 2025.
When looking at the future course of the forthcoming easing cycle, Powell has emphasized continued data dependency, with the employment part of its dual mandate now supplanting inflation as the number one priority. But, as we are currently seeing, the Fed’s balancing act is not only a matter of employment and inflation trends but also includes Fed Funds and its balance sheet.
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