Introduction to the Adam Smith Award
The Adam Smith Award is an annual recognition by the National Association for Business Economics (NABE) for leadership in the field of business economics. Recipients are selected by the NABE president for demonstrated excellence in applied economic policy. This year’s awardee, Jerome Powell, described his nomination as an “unexpected honor” in keynote remarks delivered at a luncheon held in his honor.
The Fed’s Balance Sheet
Powell discussed the Fed’s balance sheet, describing it as “one of the more arcane and technical aspects of monetary policy.” The balance sheet is a ledger of central bank-owned assets and liabilities that liquifies the U.S. financial system and a global financial network. Powell noted that when the Treasury makes or receives payments, those flows affect dollar for dollar the supply of reserves or other liabilities in the system.
Keeping Fed Independence
Domestically, the context surrounding Powell’s speech is extraordinary if not unprecedented. President Donald Trump has vented his frustration about perceived delays in lowering interest rates, and a divisive rate-cut pressure campaign has been waged against Powell. This has left just 4% of economists surveyed by NABE to report confidence in the Fed staying “fully independent.” Powell finds himself stewarding a split coalition of central bank policymakers, with opinions on future cuts varying.
Past Policy Mistakes
Powell discussed the Fed’s recent dalliances with its balance sheet, noting that extravagant loosening of monetary and fiscal policy during the COVID-19 pandemic have amplified historically unique challenges facing Fed policymakers today. The Fed purchased Treasury and agency securities at an extraordinary pace in March and April of 2020, and balance sheet expansion continued in 2021 to avoid a sharp unwelcome tightening of financial conditions. Powell confessed that with the clarity of hindsight, the Fed could have and perhaps should have stopped asset purchases sooner.
Balance Sheet Strategy
Since June 2022, the Fed has reduced its balance sheet by $2.2 trillion, from 35% to nearly 22% of U.S. gross domestic product. However, Powell suggested that the Fed does not seek to reconstitute its pre-pandemic balance sheet or balance sheet strategy. The size of the balance sheet is determined by the public’s demand for its liabilities rather than by pandemic-related asset purchases. The Fed balance sheet is overweight longer-term securities and underweight shorter-term securities relative to the outstanding universe of Treasury securities.
The Importance of the Ample Reserves Regime
Powell explained that the “ample reserves” regime has proven remarkably effective for implementing monetary policy and supporting economic and financial stability. If the ability to pay interest on reserves and other liabilities were eliminated, the Fed would lose control over rates. To restore rate control, large sales of securities over a short period of time would be needed to shrink the balance sheet and the quantity of reserves in the system. However, this could strain Treasury market functioning and compromise financial stability.
Conclusion
In conclusion, Powell’s speech highlighted the complexities of the Fed’s balance sheet and the challenges facing policymakers today. The Fed’s independence is crucial, and its ability to implement monetary policy effectively is essential for supporting economic and financial stability. As the leader of the central bank, Powell’s decisions will have a significant impact on the economy, and his legacy hangs in the balance of risks that are shifting again. The Fed will set policy based on the evolution of the economic outlook and the balance of risks, rather than following a predetermined path, as markets and consumers await a breakthrough on the funding lapse holding the data hostage.
