Against the backdrop of renewed interplay between Middle East tensions and inflation prospects, two Federal Reserve Governors delivered speeches on Thursday, Eastern Time, the 26th, conveying subtle yet critical policy signals. Governor Cook explicitly stated that the conflict involving Iran has shifted the risk balance, making inflation concerns outweigh those related to employment. Governor Mellor shifted the focus to a longer-term policy framework, emphasizing that reducing the balance sheet will be a gradual process measured in years.
Overall, the Federal Reserve is simultaneously confronting short-term and long-term policy challenges. In the short term, it must address the uncertainty surrounding inflation stemming from energy shocks. In the long term, it needs to redesign the monetary policy operational framework, including bank reserve requirements and the size of the balance sheet. This dual-track challenge suggests that the future policy path may become more complex.
Governor Cook: Iran Conflict Increases Inflation Risks, Policy Trade-offs Clearly Shift Speaking in Connecticut, Federal Reserve Governor Cook stated directly that the balance of risks has changed, with inflation risks now higher than employment risks. In a Q&A session following her speech, Cook said:
"I believe that, due to the impact of the conflict involving Iran, inflation risks are currently becoming higher. As for the labor market, I consider it to be in a state of balance, but it is a precarious balance."
She pointed out that the energy price shock resulting from the conflict, combined with previous tariff factors, is intensifying pressures pushing inflation away from the 2% target. Media reports citing her post-speech comments indicated she believes inflation risks "could persist longer than expected," meaning policymakers cannot easily relax their vigilance.
In contrast, Cook's assessment of the labor market was more cautious but still balanced. She described the overall labor market as being in a "state of balance, but this balance is fragile." Data shows that US job growth has continued to slow, with insufficient hiring momentum, but has not yet shown significant deterioration.
In terms of policy implications, this assessment suggests the Fed will be more data-dependent regarding the interest rate path while maintaining high sensitivity to upside inflation risks. Particularly in the context of oil price shocks, policymakers may lean more towards "holding steady" rather than hastily shifting towards easing.
Governor Mellor: Balance Sheet Reduction Could Take Years, Assets Could Be Reduced by Up to $1-2 Trillion Unlike Cook's focus on short-term inflation, Governor Mellor concentrated on the long-term adjustment of the Fed's balance sheet.
In his recent speech and accompanying working paper, he stated that the Fed is fully capable of significantly reducing its current balance sheet, which stands at approximately $6.7 trillion, but this process "will likely take years" and must be implemented in phases.
Mellor estimated that under the current operational framework, if the demand for reserves from banks can be reduced, the Fed's asset size could potentially be reduced by $1 trillion to $2 trillion. However, he emphasized that achieving this prerequisite itself requires policy adjustments, such as:
Relaxing regulatory requirements like the Liquidity Coverage Ratio (LCR) for banks. Eliminating the "stigma" associated with banks using the discount window and the Standing Repo Facility. More actively conducting open market operations during key periods, such as quarter-ends. Enhancing the liquidity appeal of alternative assets like Treasury securities.
He clearly stated that "it will take some time before we can truly begin balance sheet reduction," until these preparatory measures are in place.
"Slow is Fast": Balance Sheet Reduction Must Coordinate with Rate Policy to Avoid Market Shocks Mellor particularly emphasized that the balance sheet reduction process must be "very slow" to allow financial markets time to adjust. He stated plainly: "It is hard to overstate the importance of moving slowly."
More crucially, he noted that balance sheet reduction itself has a tightening effect, which might need to be offset by "more interest rate cuts than in the baseline scenario." This statement implies that future policy combinations could involve a parallel scenario of "balance sheet reduction + interest rate cuts."
At a systemic level, he also cautioned that if the Fed were to return to the pre-financial crisis "scarce reserves" system, it would inevitably come at the cost of increased volatility in short-term interest rates.
Regarding the ultimate target size, Mellor suggested that returning to pre-financial crisis levels is "unrealistic," but consideration could be given to controlling the balance sheet at around 15%-18% of GDP (pre-pandemic levels), whereas the current ratio remains above 20%.
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