Powell opens the door to interest rate cuts: little change in outlook since the September meeting, significant downside risks to employment, and may be close to halting balance sheet reduction (with speech transcript)

In the last public speech related to economic and monetary policy before the Federal Reserve's meeting silence period at the end of this month, Federal Reserve Chairman Jerome Powell hinted that the U.S. labor market continues to deteriorate. Despite the government shutdown affecting economic assessments, he still retained the possibility of an interest rate cut this month. He also stated that the Fed may stop reducing its balance sheet (quantitative tightening, QT) in the coming months.

In his prepared remarks at the National Association for Business Economics (NABE) annual meeting this year, Powell indicated that since last month's Federal Reserve decision-making meeting, the employment and inflation outlook in the U.S. has not changed much over the past month. He said that although some important economic data has been delayed due to the U.S. federal government shutdown,

"Based on the data we have, it is fair to say that since our September meeting four weeks ago, the employment and inflation outlook does not seem to have changed much."

Powell then pointed out that data before the government shutdown indicated that economic growth might be slightly more robust than expected. The unemployment rate remained low in August, and wage growth has significantly slowed, which may partly stem from reduced immigration and a decline in labor force participation leading to slower labor growth.

"In this lackluster and somewhat weak labor market, the downside risks to employment seem to have increased."

Powell reiterated in his remarks that due to the increased downside risks to employment, the Fed's assessment of the balance of risks to its employment and inflation targets has changed, leading to the decision to cut interest rates in September. To address the tension between the dual objectives, "there is no risk-free policy path." He mentioned that existing data and surveys still indicate that "the rise in commodity prices mainly reflects tariffs, rather than broader inflationary pressures."

During the Q&A session, when asked whether tariffs would have a slow and sustained impact on inflation, Powell acknowledged that tariffs are a risk, but he pointed out that there are "considerable" downside risks in the labor market. The labor market is slightly undersupplied.

Powell stated that the Fed is trying to balance the risks of actions taken to achieve its dual mandate of employment and inflation. Cutting rates too quickly could "result in an unfinished inflation task," while cutting rates too slowly could lead to "painful losses in the job market." He reiterated that the path of interest rates is not without risk, saying:

"There is indeed no risk-free path right now, as (inflation) seems to be continuing to rise slowly... and now the labor market has shown considerable downside risks. Both labor supply and demand have sharply declined."

Powell noted that while the labor market is weak, economic data has "unexpectedly risen."

On Tuesday, Powell repeatedly pointed out the slow pace of hiring and noted that the employment rate may decline further. He said, "The number of job vacancies is likely to further decline, which will likely be reflected in the unemployment rate. After a period of straight-line decline, I believe we will eventually reach a point where the unemployment rate begins to rise."

Powell did not provide specific numbers to indicate where he believes the breakeven point for employment growth is, which is the baseline level for maintaining a stable unemployment rate. He stated that the unemployment rate has clearly "declined significantly." He noted that with the slowdown in employment growth, the unemployment rate has changed little, which is "very striking."Journalist Nick Timiraos, known as the "new Federal Reserve correspondent," stated that Powell is keeping the Federal Reserve on track for another rate cut. He hinted that despite inflation concerns, a rate cut may still occur this month due to a weak job market.

Economist Chris G. Collins commented that Powell said there hasn't been much change in the outlook since the September meeting, which adheres to the expectation of two more rate cuts this year announced after the September meeting. However, he did not send a strong signal for a rate cut this month, instead pointing out that "the growth trajectory of economic activity may be slightly stronger than expected."

Sufficient Reserves, Signs Indicate Liquidity Tightening, Will Act Cautiously to Avoid "Taper Tantrum"

Powell expects that the Federal Reserve may stop balance sheet reduction in the coming months. In his speech, he stated that the Fed's long-standing plan is to cease actions when reserves are slightly above the level deemed adequate by the Fed.

"We may be approaching this level in the coming months, and we are closely monitoring various indicators to inform this decision."

Powell acknowledged that there are signs indicating liquidity is gradually tightening but mentioned that the Fed's plan "indicates they will take cautious measures to avoid a situation like the monetary market tension in September 2019." Commentators believe Powell is referring to avoiding the market volatility caused by the "taper tantrum" resulting from the reduction of QE.

In September 2019, the U.S. short-term financing market experienced a "cash crunch," with overnight repurchase rates soaring to 10%, forcing the Fed to initiate overnight repurchase operations for the first time in a decade, injecting massive amounts into the money market. Wallstreetcn mentioned that mainstream research believes the repurchase crisis in September 2019 was caused by an episodic event under tight liquidity conditions. The culprits were the scarcity of excess reserves, combined with factors such as tax day, large-scale government bond issuance, and large banks needing to reserve significant amounts of reserves due to intraday liquidity regulatory measures.

During the Q&A session, Powell stated that indicators the Fed is monitoring show that reserves in the banking system remain "sufficient," but with rising repurchase rates, there are signs of some tightening in the money market conditions.

Losing Control Over Interest Rates by Not Paying Interest on Reserves Would Cause Greater Market Disruption

This year, some lawmakers have criticized and questioned the Fed's payment of interest on reserves held by commercial banks. In his speech on Tuesday, Powell defended the important tool of the reserve mechanism, stating that the Fed's reserve system is very effective and operates well, warning that if the Fed is stripped of its ability to pay interest on reserves, it will lose control over interest rates, causing greater disruption to the market.

Commentators believe that Powell's speech clearly responds to criticisms from U.S. Treasury Secretary Janet Yellen and other Republicans, who questioned the Fed's purchase of MBS, suggested that better explanations for bond purchases might be needed, and questioned whether interest should be paid on reserves. Powell recalled that the Fed might have needed to stop bond purchases more quickly after 2020This Tuesday, Powell mentioned that the Federal Reserve is considering adjusting its asset holdings to increase short-term assets.

Collins commented that increasing holdings of short-term assets such as short-term bonds is not a new idea. Some investors believe that if the U.S. Treasury increases the issuance of short-term bonds and the Federal Reserve purchases a significant portion of them, it would be akin to a form of invisible QE, as this would lower the overall weighted average interest rate of outstanding government bonds.

However, Collins pointed out that the Treasury issuing more short-term bonds does not necessarily flatten the yield curve. The primary drivers of U.S. Treasury yield curves remain policy expectations rather than changes in net supply.

Other Indicators Cannot Replace Official Data When Asked About Rising Gold Prices

During the Q&A session, Powell stated that due to the government shutdown causing the absence of data such as the non-farm payroll report, everyone is looking at the same employment data disclosed by the private sector. He emphasized state-level employment data and the ADP employment report, often referred to as "small non-farm," while stating that these data cannot replace the gold standard that constitutes official statistical data.

When discussing alternative data, Powell mentioned that some indicators can serve as a supplement to official government statistics but cannot replace these data. He noted that without government reports, accurately interpreting prices is particularly difficult.

When asked about the rise in gold prices, Powell said, "I will not comment on the price of any specific asset."

When asked about the impact of artificial intelligence (AI), Powell quoted Nobel laureate Robert Solow on how new technologies will affect productivity: "You can see computers everywhere, but not in the productivity statistics." He added, "That may be one thing."

Powell stated that Federal Reserve officials maintain a low profile and stay away from politics. "We will not engage in back-and-forth arguments with anyone. That would quickly turn into a political topic." The only goal of the Federal Reserve is to serve the public well. However, he also said, "Don't strive for perfection. These are urgent decisions that must be made in real-time."

Powell indicated that the Federal Reserve would not comment on immigration policy, but he noted that the Trump administration's policies in this regard are tougher than many expected. He stated that labor force growth and the number of entrants have sharply declined, which may lead to a reduction in workers. But we are just beginning to see the effects of these policies.

Full Text of Powell's Speech

Below is the full text of Powell's speech titled "Interpreting the Federal Reserve's Balance Sheet":

Interpreting the Federal Reserve's Balance Sheet

Federal Reserve Chairman Jerome H. Powell spoke at the 67th Annual Meeting of the National Association for Business Economics held in Philadelphia, Pennsylvania.

Thank you, Emily. I also thank the National Association for Business Economics for awarding me the Adam Smith Award. I am deeply honored to be recognized alongside past recipients, including my predecessors Janet Yellen and Ben Bernanke. Thank you for your recognition, and I appreciate the opportunity to engage with you today.

When the public understands how the Federal Reserve operates and why, monetary policy can be more effective. With that in mind, I hope to deepen the public's understanding of the Federal Reserve's balance sheet, which is a relatively obscure and technical aspect of monetary policy. A colleague recently likened this topic to going to the dentist, but that analogy may not be fair to dentists

Today, I will discuss the important role our balance sheet played during the (COVID-19) pandemic, as well as some lessons learned. Then, I will review our ample reserve implementation framework and the progress we have made in normalizing the size of our balance sheet. Finally, I will briefly talk about the economic outlook.

Federal Reserve Balance Sheet Background

One of the central bank's main responsibilities is to provide the monetary base for the financial system and the broader economy. This base consists of the liabilities of the central bank. As of October 8, the total liabilities of the Federal Reserve's balance sheet amounted to $6.5 trillion, of which approximately 95% is composed of three categories of assets. First, there are the Federal Reserve notes totaling $2.4 trillion (i.e., physical currency). Second, there are reserves totaling $3 trillion (i.e., funds held by depository institutions at the Federal Reserve Banks). These deposits enable commercial banks to make payments and meet regulatory requirements. Reserves are the safest and most liquid assets in the financial system, and only the Federal Reserve can create them. An ample supply of reserves is crucial for the safety and soundness of our banking system, the resilience and efficiency of our payment systems, and ultimately the stability of our economy.

The third category is the Treasury General Account (TGA), which currently stands at approximately $800 billion (balance), essentially serving as the federal government's checking account. When the Treasury makes payments, these funds flow in a dollar-for-dollar manner, affecting the supply of reserves or other liabilities in the system.

The assets on our balance sheet are almost entirely composed of securities, including $4.2 trillion in U.S. Treasury securities and $2.1 trillion in government-sponsored enterprise mortgage-backed securities (MBS). When we increase reserves in the system, it is often achieved by purchasing Treasury securities in the open market and crediting the reserve accounts of the selling banks. This process effectively converts publicly held securities into reserves without changing the total amount of government liabilities held by the public.

Balance Sheet as an Important Tool

The Federal Reserve's balance sheet is a key policy tool, especially when the policy interest rate is constrained by the effective lower bound (ELB). When the COVID-19 pandemic broke out in March 2020, the economy nearly came to a halt, financial markets were failing, and a public health crisis had the potential to evolve into a severe and prolonged economic recession.

To address this, we established a series of emergency liquidity arrangements. These programs were supported by Congress and the government, providing critical support to the markets and proving very effective in restoring confidence and stability. The loans provided by these arrangements peaked in July 2020 at just over $200 billion. As conditions stabilized, most of these loans were quickly unwound.

At the same time, the U.S. Treasury market—typically the deepest and most liquid market in the world, and the cornerstone of the global financial system—was under immense pressure and on the brink of collapse. We restored the normal functioning of the Treasury market through large-scale purchases of securities. In response to unprecedented market failures, the Federal Reserve purchased U.S. Treasury and agency bonds at an astonishing pace in March and April 2020. These purchases supported the flow of credit to households and businesses and created a more accommodative financial environment to support the eventual economic recoveryThe importance of this policy easing is crucial, as we lowered the federal funds rate to near zero and expected that level to be maintained for some time.

By June 2020, we slowed the pace of asset purchases to $120 billion per month, but the scale remained substantial. In December 2020, due to the still highly uncertain economic outlook, the Federal Open Market Committee (FOMC) stated that we expected to maintain this pace of purchases "until the Committee sees substantial progress toward its maximum employment and price stability goals." This guidance ensured that, in the face of unprecedented circumstances, the Federal Reserve would not prematurely withdraw support while the economic recovery remained fragile.

We maintained the pace of asset purchases until October 2021. By then, it was clear that without strong monetary policy responses, high inflation was unlikely to subside. At the November 2021 meeting, we announced a gradual tapering of asset purchases. At the subsequent December meeting, we doubled the pace of tapering and indicated that asset purchases would be completed by mid-March 2022. Throughout the purchase period, our securities holdings increased by $4.6 trillion.

Some observers questioned the scale and composition of asset purchases during the pandemic recovery, which is understandable. Throughout 2020 and 2021, the economy faced significant challenges due to widespread disruption and loss caused by successive outbreaks of COVID-19. During that tumultuous period, we continued to purchase assets to avoid a sharp and unwelcome tightening of financial conditions while the economy still appeared highly fragile. Our thinking was influenced by events in recent years, where signals of balance sheet reduction led to significant tightening of financial conditions. We considered events that occurred in December 2018, as well as the "taper tantrum" in 2013.

Regarding the composition of our purchases, given the strong recovery in the real estate market during the pandemic, some questioned whether agency MBS should be included in the purchases. Aside from purchases specifically for market operations, the primary purpose of buying MBS, like our purchases of U.S. Treasuries, was to ease broader financial conditions when policy rates were constrained at the effective lower bound (ELB). During this period, the extent of the impact of purchasing these MBS on the real estate market conditions is difficult to determine. Many factors influence the mortgage market, and many factors outside the mortgage market also affect the supply and demand dynamics of the broader real estate market.

In hindsight, we could have—perhaps should have—stopped asset purchases earlier. Our real-time decision-making aimed to guard against downside risks. We knew that once purchases ended, we could relatively quickly unwind our holdings, and that is exactly what we did. Research and experience tell us that asset purchase programs influence the economy through expectations about the future size and duration of the balance sheet. When we announced the tapering of bond purchases, market participants began to digest its implications, leading to an earlier tightening of financial conditions. Stopping bond purchases earlier might have brought some changes, but it is unlikely to have fundamentally altered the economic trajectory. Nevertheless, our experiences since 2020 do indicate that we can use the balance sheet more flexibly, and given the increasing experience of market participants with these tools, we are more confident that our communications can help them form reasonable expectations

Some people also believe that we could have better explained the purpose of the asset purchase program in real time. There is always room for improvement in communication. However, I believe our statement has clearly articulated our goals, which are to support and maintain the smooth functioning of the market and to help create a loose financial environment. Over time, the relative importance of these goals will change with the economic conditions. But these goals have never conflicted, so at that time, the issue seemed to have little difference. Of course, this is not always the case. For example, the banking stress in March 2023 led to a significant increase in our balance sheet through lending activities. We clearly distinguished these financial stability operations from our monetary policy stance. In fact, we continued to raise policy rates during this period.

Our ample reserves framework is functioning well

Returning to my second point, it has proven that our ample reserves system is very effective in controlling our policy rates under various challenging economic conditions, while promoting financial stability and supporting a resilient payment system.

Within this framework, the ample reserves supply ensures sufficient liquidity in the banking system, while we control the policy rate by setting managed rates (the interest rate on reserve balances and the overnight reverse repurchase rate). This approach allows us to maintain interest rate control without being affected by the size of the balance sheet. This is crucial given the large and unpredictable fluctuations in the liquidity demands of the private sector, as well as significant fluctuations in autonomous factors affecting reserve supply (such as TGA).

Whether the balance sheet is shrinking or expanding, this framework has proven to be resilient. Since June 2022, we have reduced the size of the balance sheet by $2.2 trillion, from 35% of GDP to just below 22%, while maintaining effective interest rate control.

Our long-standing plan is to stop balance sheet reduction when reserves are slightly above the level we judge to be sufficient. We may approach this level in the coming months, and we are closely monitoring various indicators to inform this decision. Some signs are beginning to indicate that liquidity conditions are gradually tightening, including a general strengthening of repo rates and more pronounced but temporary pressures on specific dates. The plans of the Federal Open Market Committee (FOMC) indicate that a cautious approach will be taken to avoid a repeat of the money market tensions seen in September 2019. Additionally, the tools within our implemented framework, including the standing repo facility and the discount window, will help control financing pressures and keep the federal funds rate within the target range during the transition to lower reserve levels.

Normalization of the balance sheet size does not mean returning to pre-pandemic levels. In the long run, the size of our balance sheet will depend on the public's demand for our liabilities, rather than our pandemic-related asset purchases. Currently, non-reserve liabilities are about $1.1 trillion higher than before the pandemic, which requires us to hold an equivalent amount of securities. The demand for reserves has also increased, reflecting, to some extent, the growth of the banking system and the overall economy

Regarding the composition of our securities investment portfolio, relative to outstanding U.S. Treasury securities, our portfolio currently leans towards long-term securities and is underweight in short-term securities. The long-term composition will be a topic of discussion for the committee. We will gradually and predictably transition to our desired composition, allowing market participants time to adjust and minimizing the risk of market disruption. Consistent with our long-standing guidelines, our goal is to build a portfolio primarily composed of U.S. Treasury securities over the long term.

There are concerns about whether the interest on reserves we pay will impose a heavy burden on taxpayers. This is not the case. The Federal Reserve's interest income comes from U.S. Treasury securities that support the reserves. In most cases, the interest income we earn from holding U.S. Treasury securities is sufficient to cover the interest expenses on reserves, resulting in substantial remittances to the Treasury. The law requires that all profits, after expenses, be remitted to the Treasury. Since 2008, even accounting for recent negative net income, our total remittances to the Treasury have exceeded $900 billion. Due to rapid interest rate hikes to control inflation, our net interest income is temporarily negative, but this is extremely rare. Our net income will soon turn positive, as has been common in our history. Of course, negative net income does not affect our ability to implement monetary policy or meet our financial obligations.

If we are unable to pay interest on reserves and other liabilities, the Federal Reserve would lose control over interest rates. The stance of monetary policy would no longer align with economic conditions, leading the economy away from our (full) employment and price stability goals. To restore control over interest rates, a significant amount of securities would need to be sold in the short term, thereby shrinking our balance sheet and the reserves in the system. The scale and speed of the sell-off could put pressure on the functioning of the Treasury market and harm financial stability. Market participants would need to absorb the sell-off of Treasuries and agency MBS, which would put upward pressure on the entire yield curve, thus increasing borrowing costs for the Treasury and the private sector. Even after navigating this turbulent and chaotic process, the resilience of the banking system would be diminished, making it more susceptible to liquidity shocks.

Most importantly, our ample reserves system has proven to be very effective in implementing monetary policy and supporting economic and financial stability.

Current Economic Conditions and Monetary Policy Outlook

Finally, I will briefly discuss the economic and monetary policy outlook. Although some important government data has been delayed due to the government shutdown, we regularly assess various public and private sector data that remain available. We have also established a national network of contacts through the various (regional) Federal Reserves, who provide valuable insights that will be summarized in tomorrow's (Federal Reserve) Beige Book.

Based on the data we have, it is fair to say that since our September meeting four weeks ago, the employment and inflation outlook does not appear to have changed significantly. The data obtained before the government shutdown indicated that the trajectory of economic activity may be more robust than expected.

While the unemployment rate remained low in August, wage growth has slowed significantly, which may partly stem from a decline in labor growth due to immigration and labor force participation rate decreases. In this lackluster and somewhat weak labor market, the downside risks to employment seem to have increasedAlthough the official employment data for September has been delayed, existing evidence indicates that both layoffs and hiring remain at low levels, and households' perceptions of available job openings and businesses' perceptions of hiring difficulties continue to decline.

At the same time, the core Personal Consumption Expenditures (PCE) inflation rate for the 12 months ending in August was 2.9%, slightly higher than earlier this year, due to the rise in core goods inflation outpacing the ongoing decline in housing services inflation. Existing data and surveys continue to suggest that the rise in goods prices primarily reflects tariffs rather than broader inflationary pressures. Consistent with these influences, short-term inflation expectations have generally risen this year, while most long-term inflation expectation indicators remain aligned with our 2% target.

The increased downside risks to employment have altered our assessment of the risk balance. Therefore, we believe that a more neutral policy stance is more appropriate for the September meeting. As we strive to navigate the tension between our employment and inflation objectives, there is no policy path without risks. This challenge is evident in the differences in predictions among committee members at the September meeting. I want to emphasize again that these predictions should be understood as a range of potential outcomes, with the probabilities of occurrence changing as new information continuously influences our decisions at successive meetings. We will formulate policy based on the evolution of the economic outlook and risk balance, rather than following a predetermined path