Fed Signals End of Interest Rate Increases
Markets have blamed the recent volatility on the Fed’s balance sheet runoff, saying it was causing investors to dump riskier assets like stocks and corporate bonds and snap up safer Treasurys and mortgage securities. The Fed’s bond-buying program, known as quantitative easing, tried to goose the economy by holding down long-term interest rates and encouraging investors to buy riskier investments.
On Wednesday, the Fed released a second statement indicating it could change the pace and path of its portfolio reduction and keep more money in the bond market if necessary.
“The committee is prepared to adjust any of the details for completing the balance sheet normalization in light of economic and financial developments,” the statement said. It added the Fed also stood willing to increase the size of the balance sheet, if necessary.
The decision has limited implications for the general public. Some Fed officials and outside experts think that the new approach has improved the Fed’s ability to influence economic conditions, but the practical difference is generally regarded as modest.
Before the financial crisis, the Fed influenced economic conditions by adjusting the quantity of reserves in the banking system. Banks are required to hold reserves in proportion to deposits, so constraining the supply forced banks to compete for the available reserves by paying higher interest rates. That, in turn, caused banks to raise interest rates on loans.
During the crisis, the Fed pumped enough reserves into the banking system to cut short-term interest rates nearly to zero. Then it continued to pump reserves into the system, purchasing Treasuries and mortgage bonds to bring down long-term rates.
The result is a system still awash in reserves.
Since 2015, the Fed has gradually raised short-term rates by simulating a scarcity of reserves: It pays banks to leave the extra money untouched.
“The ultimate size of our balance sheet will be driven primarily by financial institution demand for reserves,” Mr. Powell said on Wednesday, adding that “estimates of the level of reserve demand is quite uncertain.”