Federal Reserve Powell: Cutting interest rates while continuing to shrink balance sheet

Federal Reserve Chairperson Jerome Powell said on Wednesday that liquidity levels in the financial system remain strong, which will allow the central bank to continue shrinking its balance sheet even as it begins to cut interest rates. "Reserves remain abundant and are expected to remain so for some time," Powell said at a news conference after the monetary policy meeting, where the Fed kicked off the easing cycle with a relatively large 0.5 percentage point rate cut, with further rate cuts to come as inflation recedes.

Powell spoke of the so-called quantitative tightening (QT) process, in which the Fed takes back the liquidity it pumped through bond purchases during the COVID-19 pandemic. So far, the Fed has reduced the total size of its balance sheet from a peak of $9 trillion in summer 2022 to $7.20 trillion now.

(Changes in the size of the Federal Reserve's balance sheet)

The Fed slowed the pace of tapering earlier this year and now allows up to $60 billion a month in Treasury and mortgage bonds to mature without replacement. The process of quantitative tightening began against the backdrop of the Fed's aggressive interest rate hikes to contain inflationary pressures.

Fed officials have repeatedly said that they view QT as a back-office process, with interest-rate adjustments their main tool for influencing the economy. Quantitative tightening is different from quantitative easing (or bond buying), which is typically conducted in volatile markets to make monetary policy more effective when interest rates are near zero.

Some analysts had speculated that a 0.5 percentage point cut could hasten the end of quantitative tightening to better align the Fed's entire toolkit. Doing so would avoid a complex situation in which interest rate policy is loose while balance sheet policy actually tightens financial conditions by allowing long-term yields to rise.

At a news conference, Powell noted that most of the balance sheet reduction has largely not touched bank reserves held at the Fed, but rather stripped cash from reverse repurchase facilities, which have hovered above the $3 trillion mark since June 2022.

At the same time, the inflow of reverse repurchase funds has reduced the amount of money that money funds keep in the instrument every day from more than $2 trillion to $305.80 billion on Wednesday.