Opening remarks at panel on Market Monitoring and the Implementation of Monetary Policy

Speech by President Lorie K. Logan

Dallas Fed President Lorie Logan delivered these remarks at the annual meetings of the International Banking, Economics and Finance Association and the American Economic Association.

Thank you, Diana [Hancock]. It’s great to be at this important annual gathering and have the opportunity to discuss the policy outlook with you, Viral [Acharya] and Markus [Brunnermeier]. I’ll begin with some thoughts on the state of the economy and monetary policy and then turn more specifically to the Fed’s balance sheet and how we are implementing policy in money markets. As always, the views I express are mine and not necessarily those of my colleagues on the Federal Open Market Committee (FOMC).

As we look back over the past year, inflation today is in a much better place than last January. But the job of restoring price stability is not yet complete. Our challenge now is to finish the work of bringing inflation sustainably back to the 2 percent target.

Inflation data have generally been coming in cooler than expected, which is good news. The price index for personal consumption expenditures (PCE) was nearly flat for November and up 2.6 percent over the past year. The Dallas Fed trimmed mean PCE inflation rate, which drops outliers, is 2.6 percent for the past three and six months. And core PCE increased at only around a 2 percent pace over the past three and six months, an improvement from the middle of 2023 when inflation appeared to be getting stuck at a higher level.

And there’s clear evidence that the economy is moving into better balance. While GDP grew at an unsustainably strong 4.9 percent annual rate in the third quarter, preliminary readings suggest the fourth quarter will be substantially slower. My business and community contacts consistently report that growth is settling down—not collapsing, not heading toward recession, but settling down.

The labor market, while still tight, also continues to rebalance. The pace of payroll job gains over the past several months has remained strong but is well below the pace at the start of 2023. The ratio of job vacancies to unemployed workers has fallen, as has the rate of workers quitting their jobs. And wage growth appears to be somewhat more consistent with our 2 percent inflation target. Contacts tell me that applicant pools are growing, and job candidates’ salary expectations are moderating. This is a more consistent picture than we had earlier in 2023. It gives me confidence that we have made a lot of progress toward a more sustainable path for the economy.

So, what could derail this benign outlook of inflation returning sustainably to our target as the economy gradually rebalances? There are, as always, plenty of risks: geopolitical threats to supply chains, financial fragilities in sectors such as commercial real estate and just the simple possibility that our forecasts are once again wrong, as they’ve been too many times in recent years. A key risk related to the topic of this panel is that a premature easing of financial conditions could allow demand to pick back up. Restrictive financial conditions have played an important role in bringing demand into line with supply and keeping inflation expectations well-anchored. Yet over the past few months, long-term yields have given back most of the tightening that we saw over the summer. We can’t count on sustaining price stability if we don’t maintain sufficiently restrictive financial conditions.

Much of the easing in long-term yields since October came in response to softer economic data or policy communications. Ordinarily, that pattern would suggest that markets expect the FOMC won’t need as restrictive a setting of the federal funds rate to accomplish our goals. But the magnitude of the reactions to data was much greater than normal. Part of what appears to be happening is that when the data are strong, as occurred over the summer, market participants perceive a wider range of potential rate outcomes and require compensation for that risk in the form of higher term premiums. And when the data soften, as happened recently, that term premium comes out because market participants perceive more of an upper bound on policy rates. Some model-based term premium estimates remain higher than levels seen last summer, but I’m mindful that all else equal, a lower term premium leaves more work to be done with the fed funds target.

Financial conditions indexes (FCIs) can provide a guide to how much restraint there is on the economy. I’ll talk today about four indexes that I find particularly informative. Three of the indexes are helpful because they weight financial variables based on their relationship to economic activity in macroeconomic models. These are the Goldman Sachs FCI and two FCIs published by the staff of the Federal Reserve Board: a baseline index that allows financial conditions to affect the economy with a lag of up to three years and an alternate index that allows lags of at most one year. The fourth index, published by the Chicago Fed, is more statistical in nature and doesn’t translate directly to an effect on economic activity, but it includes a much wider range of financial variables.

The Board staff’s baseline index shows a drag on GDP growth from tight financial conditions in the coming year. But that’s because the index assumes long lags. My staff produced an updated calculation of the Board staff’s alternative index with one-year lags, and it shows a tailwind to growth. The Goldman Sachs FCI shows something similar. My own view is that the right answer is somewhere in between. These indexes include only a subset of asset prices. Looking across the financial system as a whole, we’re still seeing tightening from bank credit and refinancing of term corporate debt. But a lot of the effects of higher rates are already behind us, and the recent easing in conditions could start to push up on aggregate demand. The Chicago Fed’s FCI, which statistically combines 105 different financial variables, shows that conditions are modestly less restrictive than a year ago and than their average over the past half century.

As I said earlier, if we don’t maintain sufficiently tight financial conditions, there is a risk that inflation will pick back up and reverse the progress we’ve made. In light of the easing in financial conditions in recent months, we shouldn’t take the possibility of another rate increase off the table just yet.

Turning to the Fed’s balance sheet and policy implementation, we have reduced our securities holdings since mid-2022 at a brisk pace consistent with the principles and plans that the FOMC announced earlier that year. While securities holdings have declined by $1.3 trillion, bank reserve balances have actually risen by $350 billion dollars to around $3.5 trillion. That’s because reduced balances in the Federal Reserve’s overnight reverse repurchase agreement (ON RRP) facility have more than offset the decline in securities holdings. Increased Treasury issuance and a less uncertain interest rate path have contributed to the rapid ON RRP runoff by motivating money market funds to invest more in Treasury bills.

Money markets and policy implementation are continuing to function smoothly. As we did in 2018 and early 2019, we are likely to see modest, temporary rate pressures as our balance sheet shrinks and our liabilities redistribute. These rate pressures can be a price signal that helps market participants redistribute liquidity to the places where it’s needed. Experience shows that these pressures tend to emerge first on dates when liquidity is unusually encumbered or is draining out of the system especially rapidly, like tax-payment dates, Treasury settlements and month-ends. And indeed, we saw small, temporary rises in the Secured Overnight Financing Rate (SOFR) over the November–December and year-end turns. But on nearly all days, broad money market rates have remained well below the interest rate on reserves.

The emergence of typical month-end pressures suggests we’re no longer in a regime where liquidity is super abundant and always in excess supply for everyone. In the aggregate, though, as rate conditions demonstrate, the financial system almost certainly still has more than ample bank reserves and more than ample liquidity overall. The most recent Senior Financial Officer Survey shows that most banks in the sample have reserves well in excess of their lowest comfortable levels and desired buffers. ON RRP balances remain around $700 billion. And the Federal Reserve’s Standing Repo Facility (SRF) provides a backstop against any unexpected pressures.

Still, individual banks can approach scarcity before the system as a whole. In this environment, the system needs to redistribute liquidity from the institutions that happen to have it to those that need it most. The faster our balance sheet shrinks, the faster that redistribution needs to happen. I’d note that the current pace of asset runoff is around twice what it was in the first half of 2019. And while the current level of ON RRP balances provides comfort that liquidity is ample in aggregate, there will be more uncertainty about aggregate liquidity conditions as ON RRP balances approach zero.

So, given the rapid decline of the ON RRP, I think it’s appropriate to consider the parameters that will guide a decision to slow the runoff of our assets. In my view, we should slow the pace of runoff as ON RRP balances approach a low level. Normalizing the balance sheet more slowly can actually help get to a more efficient balance sheet in the long run by smoothing redistribution and reducing the likelihood that we’d have to stop prematurely.

Lastly, I want to take note of the Securities and Exchange Commission’s adoption last month of a requirement for broader central clearing for cash and repo transactions in the Treasury market. While broader central clearing won’t cure all of the market’s vulnerabilities, our research at the Dallas Fed finds that it will have significant benefits. Related to my previous comments, broader central clearing should make repo markets more elastic as multilateral netting can reduce intermediaries’ balance sheet costs. That will help smooth the redistribution of liquidity when balance sheets are constrained, such as during stress episodes and at period ends. Broader central clearing should also meaningfully improve risk management, in particular by mitigating risks at interdealer brokers in the cash market and by addressing the 74 percent of noncentrally cleared bilateral repos that are currently transacted with zero haircuts. Of course, careful implementation by the industry and regulators will be important. The SEC has established a phased timeline, with full compliance in 2026. As the market moves toward broader clearing, I think the FOMC should also consider the benefits of central clearing of the Federal Reserve’s own Treasury market operations. The SEC regulation exempts central banks, but in my view, it’s typically most efficient and effective for us to operate in the same way as the main market participants. And, as I’ve discussed previously, central clearing of the SRF could make that facility more effective in providing backstop liquidity to the broad market.

Thank you.

Lorie K. Logan is president and CEO of the Federal Reserve Bank of Dallas.

The views expressed are my own and do not necessarily reflect official positions of the Federal Reserve System.




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