Federal Reserve Monetary Policy Report: Plan to stop balance sheet reduction at the right time

On February 8, the Federal Reserve released its semi-annual monetary policy report, which mentioned that the Federal Reserve continues to reduce its holdings of U.S. Treasuries and agency securities in a predictable manner. Since June 2024, the Federal Reserve has reduced its holdings by $297 billion, and the total reduction in securities holdings since the start of the balance sheet reduction is about $2 trillion. The Federal Open Market Committee (FOMC) stated that it intends to maintain the securities holdings at a level consistent with the efficient implementation of monetary policy under an ample reserves regime. To ensure a smooth transition, the FOMC slowed the pace of the securities holdings reduction in June 2024 and plans to stop reducing the securities holdings when the reserve balances are slightly above the level it deems consistent with an ample reserves regime. Supported by a robust labor market and rising real wages, consumer spending continues to grow strongly, while real business fixed investment is growing moderately. In the housing market, new home construction has been stable, but existing home sales remain depressed as mortgage rates remain high. In contrast to the situation with gross domestic product, manufacturing output has changed little, partly due to weak production in interest-rate-sensitive industries. The U.S. financial system remains healthy and resilient. Valuations in a range of markets, including equities, corporate debt, and residential real estate, remain elevated relative to fundamentals. The ratio of total debt of households and nonfinancial businesses to GDP continues to decline and is currently at a very low level compared to the past two decades. Most banks report capital levels well above regulatory requirements and have reduced their reliance on uninsured deposits, but some banks have experienced large fair value losses on fixed-rate assets. In terms of funding risks, while the 2023-2024 Securities and Exchange Commission reforms have partially mitigated the vulnerabilities of major money market funds (MMFs), other less-regulated short-term investment vehicles remain susceptible to shocks and lack transparency, and their asset size continues to grow. At the same time, hedge funds appear to have relatively high and concentrated leverage.