Powell's balance: No excessive rate cuts, but will stop balance sheet reduction

At the annual meeting of the National Association for Business Economics held in Philadelphia, Powell delivered a speech before entering the FOMC's quiet period this month, with a relatively restrained tone. Against the backdrop of intertwined interest rate cuts and inflation expectations, Powell is cautiously adjusting monetary policy, trying to find a balance among multiple objectives.

Over the past two years, the Federal Reserve has maintained high interest rates and continued quantitative tightening with the primary task of controlling inflation, in order to maintain an overall tightening tone. However, recent signs indicate that this tightening cycle may be nearing its end, with policy beginning to shift towards "measured easing": on one hand, considering measured interest rate cuts to avoid rising inflation expectations, and on the other hand, also using balance sheet operations to avoid liquidity tightening.

Powell clearly pointed out that although the government shutdown has led to some missing economic data, existing information shows that the trends in employment and inflation are not significantly different from a month ago, and economic growth is even slightly stronger than expected. However, there are also some signs of weakness in the labor market, such as a slowdown in hiring and a decrease in job vacancies. Although the unemployment rate remains low, it may face upward pressure in the future. Powell admitted, "The downside risks to employment seem to have increased," a statement that has drawn widespread attention from the market and is seen as suggesting a 25 basis point rate cut again this month.

However, the Federal Reserve will remain cautious. Powell emphasized that any policy choice carries risks: cutting rates too quickly could lead to a rebound in inflation, while cutting too slowly could affect employment. The latest interest rate forecast chart indicates that there may be one or two rate cuts this year, but internal opinions are not uniform: some officials want to act faster, while others are concerned about price pressures from tariffs and supply chain issues, and some advocate that "one cut is enough." This divergence reflects Powell's "tightrope walking" in policy.

Meanwhile, another policy is quietly advancing. Powell hinted that the Federal Reserve may soon stop balance sheet reduction. Although the reserves in the banking system remain ample, signs such as rising repo rates indicate that market liquidity is tightening. He stated that the Federal Reserve will operate cautiously to avoid a repeat of the severe fluctuations in the repo market in 2019. At that time, overnight rates soared to 10%, causing market panic. Stopping balance sheet reduction is not only a technical adjustment but also aims to stabilize the market by improving liquidity without relying excessively on interest rate cuts.

Regarding the balance sheet, Powell spent considerable time explaining the importance of the reserve system. In response to criticisms from some regarding the payment of interest on reserves, he replied that if the Federal Reserve cannot continue to pay interest on reserves, it may lose control over interest rates and even have to sell large amounts of government bonds and mortgage-backed securities, thereby pushing up market rates and affecting financial stability. This is not only a technical issue but also relates to the effectiveness of monetary policy. His explanation also addressed recent congressional concerns about this mechanism, emphasizing that it is a key tool for maintaining market stability Regarding inflation, the core PCE index remains around 2.9%, slightly higher than at the beginning of the year, primarily driven by rising commodity prices due to tariffs, while inflation related to housing services is declining. Powell reminded everyone that in the absence of government data, alternative data cannot fully replace official statistics, so judgments about price trends need to be more cautious. He also refrained from commenting on gold prices to avoid guiding market expectations.

In terms of market interpretation, Wall Street Journal reporter Nick Timiraos pointed out that Powell's remarks indicate that the Federal Reserve is still considering interest rate cuts but will adjust based on data and risks. This strategy is both a response to the current economic situation and a management of market expectations. Powell emphasized that policies will not simply replicate past paths but will be decided based on the circumstances of each meeting.

This policy "balancing act" is reflected not only in the relationship between interest rates and the balance sheet but also involves policy communication and political boundaries. Powell reiterated that the Federal Reserve will not intervene in political affairs, such as immigration policy, but he also acknowledged that slowing labor force growth and reduced immigration could impact the job market. He quoted Nobel laureate Robert Solow, reminding everyone not to overinterpret the short-term impact of artificial intelligence on productivity.

In the coming months, the Federal Reserve's dual-track operation of moderating interest rate cuts and halting balance sheet reduction will become the focus of market attention. For investors, understanding this policy balance is more important than simply betting on a single policy. Powell's strategy is both a response to economic realities and an adjustment to market psychology.

For the market, long-term interest rates will appear relatively sticky under this "balance," which seems to imply that the dollar index will struggle to decline rapidly, and may even appear easier to rise than to fall in a relatively sluggish long-term interest rate environment. Short-term interest rates may decline due to quasi-quantitative easing operations, but could rebound due to intermittent liquidity tightening in reality (otherwise, the Federal Reserve would not consider quasi-quantitative easing policies). In this case, the best choice for the market may actually be to buy long-term bonds during liquidity tightening, as this is when the Federal Reserve most needs to express a dovish stance.

Author of this article: Zhou Hao, Source: GTJAI Macro Research, Original title: “【Guotai Junan International Macro】Powell's Balance: Not Overly Cutting Rates, but Will Stop Balance Sheet Reduction”

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