How to Interpret the Fed Balance Sheet’s Developments

The Federal Reserve of the United States (Fed) did not disappoint markets in this crisis. Under Jay Powell’s leadership, the Fed seems more proactive than ever, improving even its communication strategy. 

Press conferences held by Powell are simple, send a clear and strong message, and leave no room for interpretation. When the Fed announced more quantitative easing (QE) in response to the coronavirus pandemic, it delivered. It delivered big.

The Fed’s balance sheet, that one item that shows what the central bank owns, increased significantly in a matter of months. More precisely, it almost doubled since the end of 2019. It sits now close to $7 trillion, with no sign of the purchases slowing down anytime soon.

Today’s Powell’s Speech in Focus

Fed’s Powell is about to deliver a speech today as the Jackson Hole Symposium begins. Titled “Monetary Policy Framework Review”, it hints to a change in the way the Fed views its mandate.

Rumors in the market suggest that the Fed is about to shift to average inflation targeting and maybe even yield curve control. Out of the two, the likelihood is that the first option would be mentioned. As always, there is no rumor without some actual facts behind; otherwise at least one of the Fed members would have come out and denied the rumors.

If average inflation targeting comes out (still a concept difficult to grasp for many traders and investors on first reading), the Fed’s balance sheet should expand even further. In fact, the pace of expansion will increase. The balance sheet anyways expands at the current pace, but with average inflation targeting commitment from the Fed, the pace shifts to a higher gear.

No matter how you put it, the Fed seems trapped today. On the one hand, the average inflation targeting news seems to be priced in by the market participants. However, it depends on the level of commitment the Fed describes, it may be that a threshold would be announced, specific forward guidance, and so on. In this case, the USD will decline further.

On the other hand, more QE means lower yields down the road. Even lower than they are now – currently sitting at depressed levels. It means that the Fed is in a tricky place, and communication today is more important than the actual decision. Traders do not know the commitment level, but they have an idea about the message.

Prepare for some wild end of the trading month.

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