Jerome Powell recently testified in front of Congress. This caught my attention:
So the Fed's balance sheet is about $4.5 trillion now, and we know that it will be much smaller than that when it reaches its new -- its new sort of equilibrium size. It will be larger, however, than it was before the crisis.
And we've also said that it will consist primarily -- mostly of Treasury securities, at that time, and it will be no larger then it needs to be for us to conduct monetary policy. We will be shrinking the balance sheet by allowing securities, as they mature, to roll off passively. And that should -- that process should take three or four years before we -- before we reach our new sort of stable level of the balance sheet.
And the factors that will determine that will be, really, in the end, the public's demand for our liabilities, particularly cash and reserves. Those will be principal factors that will -- that will decide what the final size of the balance sheet will be.
We don't actually know what that demand will be, but, my own thinking, it moves us to a balance sheet of in the range of, as I mentioned, $2.5 trillion to $3 trillion. I don't -- again, there's no certainty in that.
There is a sense in which the size of the balance sheet can be viewed as demand determined, especially if the Fed is targeting inflation at 2%. But that's only true if the Fed doesn't pay interest on reserves. Without interest on reserves (IOR), the Fed's balance sheet would be about 7% of GDP, slightly above the demand for currency. But with IOR, the balance sheet can be whatever the Fed wants it to be. The figures cited by Powell ($2.5 to $3.0 trillion) are more than 10% of GDP and imply the Fed will continue paying IOR, which is no surprise. But that means it will be the Fed, not the public's demand for cash and reserves, that will determine the size of its balance sheet, .
KENNEDY: What did the community banks do wrong to contribute to the meltdown in 2008?
POWELL: Fair to say that the community banks did not contribute to the meltdown in 2008.
Is this true? I was under the impression that smaller banks made lots of bad loans during the mid-2000s. Didn't most of the bank failures (during 2008-13) occur among smaller banks?
Overall I was struck by the fact that there were relatively few questions on monetary policy, and even those were often on somewhat tangential issues. Nothing on negative IOR, a different inflation target, Bernanke's recent level targeting proposal, NGDP targeting, etc. Most questions involved financial regulation. Powell handled the monetary questions skillfully, which is a good sign. But he was never really pressed on a difficult point.
One of the ongoing puzzles of the US economy in recent decades is why inflation has stayed so low. Even outgoing Fed Chair Janet Yellen has highlighted this puzzle. The "Amazon effect" may be part of the answer: basically, the Amazon effect is that a higher level of competitive pressure from the rising level of on-line retail sales is holding back price increases that might otherwise have occurred.
There are cases where increases in aggregate supply can hold down inflation--for any given increase in NGDP. Indeed this occurred during the late 1990s. However this is not the cause of low inflation today, as productivity growth is also quite slow. Rather the low inflation is caused by low NGDP growth. Of course even if inflation were being held down by rapid growth in productivity, the Fed should offset that with monetary stimulus if they want to hit their inflation target. (Or better yet, just target NGDP and allow the low inflation.) But again, that's not why inflation is currently running at low levels---it's excessively tight money that is causing the low inflation.