Federal Reserve Governor Michelle Bowman expressed her preference for a more measured approach to tapering the U.S. central bank’s balance sheet run-off during a speech at a Bank of Japan conference in Tokyo on Tuesday. Bowman indicated that she would have supported either delaying the start of the tapering process or implementing a more moderate reduction than what was announced earlier this month.
In her prepared remarks, Bowman highlighted that commercial bank reserve levels at the Fed remain substantial, allowing officials additional time to proceed with the $95 billion-a-month reduction target set since mid-2022. “While it is important to slow the pace of balance sheet runoff as reserves approach ample levels, in my view we are not yet at that point,” Bowman noted, particularly with significant utilization of the Fed’s overnight reverse repo facility (ON-RRP).
The reserve levels that banks maintain at the Fed are crucial for determining the overall size of the central bank’s balance sheet. This balance sheet has contracted from approximately $9 trillion in 2022 to about $7.4 trillion currently, through a process known as quantitative tightening. The Fed is keen to avoid a repeat of the September 2019 incident, where an excessive reduction in the balance sheet led to volatility in short-term funding markets.
On May 1, the Fed announced a plan to slow the balance sheet reduction pace. Currently, the Fed allows up to $60 billion of Treasuries and $35 billion of mortgage-backed securities to mature from its bond portfolio without replacement. Starting next month, the cap for Treasuries will decrease to $25 billion, while the MBS maturity limit will remain unchanged. Minutes from the April 30-May 1 meeting, released last week, revealed that not all Fed officials agreed with the timing of this shift. Bowman’s comments confirm that she was among the “few participants” who preferred to delay the change.
“In my view, it is important to continue to reduce the size of the balance sheet to reach ample reserves as soon as possible and while the economy is still strong,” Bowman emphasized. “Doing so will allow the Federal Reserve to more effectively and credibly use its balance sheet to respond to future economic and financial shocks.” She also stressed the need for clear communication from Fed officials to ensure that any adjustments in the balance sheet runoff do not imply a shift in monetary policy, including interest rates.
The Fed has maintained its benchmark interest rate in the 5.25% to 5.50% range since last July. Recent statements from officials indicate no immediate rush to cut rates, given the persistent inflationary pressures.
Regarding long-term balance sheet strategy, Bowman expressed a preference for a portfolio primarily composed of Treasuries, with a slight tilt towards shorter-dated maturities to enhance the Fed’s flexibility.
Expanded Analysis:
Bowman’s cautious stance on the Fed’s balance sheet tapering underscores the complexities of managing economic stability amid varying market conditions. Her insights suggest a prudent approach to ensure that the reduction in reserves does not inadvertently trigger market volatility, as seen in past instances.
Investors should consider the implications of the Fed’s measured approach. Slower balance sheet reduction could sustain higher liquidity levels, potentially supporting equity markets and easing funding conditions. However, the Fed’s cautious stance also indicates vigilance against premature policy shifts that could destabilize economic recovery.
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