Fed Balance Sheet Drawdown May Continue if Jobless Rate Remains Steady

The Federal Reserve may find it increasingly challenging to label future aggressive interest rate cuts as “normalization” if the unemployment rate remains higher than expected, according to analysts at Citi.

In a recent communication, the analysts suggested that the Fed might be compelled to end its ongoing balance sheet reduction, even with high reserves, due to this scenario.

After a significant 50-basis point interest rate cut last month, Fed Chair Jerome Powell indicated that the central bank does not plan to halt its balance sheet reductions, as reserves are still deemed “abundant” and likely to remain so for a considerable time.

Consequently, Powell asserted that continuing the process known as quantitative tightening—which involves reducing the liquidity that was increased through bond purchases during the COVID-19 pandemic—is necessary. Thus far, this process has decreased the Fed’s holdings from $9 trillion in 2022 to approximately $7.1 trillion currently.

The Citi analysts forecast that as long as the unemployment rate stabilizes at a maximum of 4.4% and job growth remains steady, the Fed will likely continue its balance sheet runoff until the end of the second quarter in 2025.

Investors will soon have the opportunity to analyze a new jobs report expected on Friday, which could provide insights into the future direction of Fed policy. Several officials have highlighted the need to support the labor market in a period of declining inflation as a key reason behind last month’s substantial rate cut.

Economists anticipate that the US economy will add around 144,000 jobs in September, a slight increase from 142,000 in the previous month. The unemployment rate is projected to remain at 4.2%, the same level as August.

In August, payrolls increased from a significantly revised figure of 89,000, falling short of forecasts which had estimated 164,000 jobs added, while the unemployment rate decreased from 4.3%.