Markets Struggle With the Meaning of ‘Substantially’

Over the years, the Federal Reserve has used rather ordinary words and phrases to describe its attitude toward monetary policy that have nevertheless beguiled investors as to their true meaning. For example, what exactly constitutes a “gradual” pace of interest-rate increases? Fed Chairman Jerome Powell may have just come up with a new one for market participants to debate: substantially.

At the Economic Club of Washington, D.C., on Thursday, Powell said the central bank is sticking with its process of shrinking its balance sheet assets to a more normal level, which removes stimulus put into place to revive the economy after the financial crisis and recession a decade ago. The balance sheet, which reached a peak of $4.52 trillion before falling to a recent $4.06 trillion, “will be substantially smaller than it is now” though bigger than it was before the crisis, Powell said. He said he didn’t know the exact level. This is important because many investors and strategists contend that the expanding balance sheet was one of the primary drivers of the big gains in equities and riskier assets in recent years. And the reason riskier assets performed so badly in late December was because Powell, during his press conference after raising interest rates on Dec. 19, largely dismissed the building turmoil in markets and suggested the balance sheet rundown that began in late 2017 would remain on a sort of autopilot. But what markets truly want is some clarity on what Powell and the Fed think the appropriate size of the balance sheet should be and how fast it will get there. Is it closer to the less than $1 trillion it was before the financial crisis, or the midpoint of $3.52 trillion since then or something else? Powell and the Fed probably don’t know the answer, but it’s sure to become a hot topic anytime Powell gives a speech or holds a press conference after a monetary policy meeting.