Fed Chairman Jerome Powell hinted that the central bank may stop shrinking its balance sheet in the coming months.

The Fed chairman also indicated that the labor market outlook continues to deteriorate, a message that supports investor expectations for another interest rate cut this month.

"Our long-held plan is to stop shrinking the balance sheet when foreign exchange reserves are slightly above a level we judge to be consistent with adequate foreign exchange reserve conditions," Powell said Tuesday in prepared remarks for an event with the National Association for Business Economics in Philadelphia.

"We will likely reach that point in the coming months, and we are closely monitoring a variety of indicators to inform this decision," Powell said.

Fed officials have been reducing the central bank's balance sheet since 2022—a process known as quantitative tightening—reversing trillions of dollars in asset purchases designed to stimulate the economy after the pandemic struck. Earlier this year, the Fed slowed the pace by reducing the amount of bond holdings it allows to roll over each month. As bank reserves decline, there has been a persistent funding squeeze in the US money market, suggesting the central bank may be getting closer to reaching a point where it wants to halt the flow of funds.

On Tuesday, Powell acknowledged that there have been "some signs" of gradual tightening. "The committee's plan sets out a deliberately cautious approach to avoid money market stress like that experienced in September 2019," he said, referring to a period of market volatility known as the "taper tantrum."

Fed officials appear divided on how low they can take bank reserves while avoiding market volatility. Fed Vice Chair for Supervision Michelle Bowman said in late September that the Fed should strive for the smallest possible balance sheet, with reserve balances at a level closer to scarcity than sufficiency. Governor Christopher Waller has said that the optimal reserve level is around $2.7 trillion.

Interest on Reserves

Powell also argued that the Fed's primary tool for implementing monetary policy—paying interest on reserves held by commercial banks at the central bank—is working well. These interest payments have been a focus of concern for some Washington lawmakers this year.

Powell said the tool allows the central bank to "precisely" calibrate its monetary policy stance.

The tool was approved by lawmakers nearly two decades ago to support the financial system and was used during the Global Financial Crisis. It has become an integral part of the Fed's ability to control short-term interest rates.

"If our ability to pay interest on reserves and other liabilities were eliminated, the Fed would lose control of interest rates," Powell said. "The bottom line is that our abundant reserve regime has proven to be a highly effective way of implementing monetary policy and supporting economic and financial stability."

Powell said in June that a proposal to eliminate the IORB would not save money, and returning to a scarce reserve regime would be challenging and risk volatility. The U.S. Senate last week rejected an amendment that would have prohibited the Fed from paying interest on bank reserves by a vote of 14-83. (alg)

Source: Bloomberg