Federal Reserve Board Member: Iran conflict has led to inflation risks exceeding employment; balance sheet reduction could take several years

Ask AI · How the Iran conflict is reshaping the Federal Reserve’s policy priorities

As the Middle East situation and inflation outlook intertwine once again, two Federal Reserve governors spoke on Thursday, Eastern Time, signaling subtle but crucial policy signals. Among them, Governor Cook explicitly stated that the Iran conflict has shifted the inflation risk back above employment. Governor Mester focused the discussion on a longer-term policy framework—emphasizing that balance sheet reduction will be an “annualized” gradual process.

Overall, the Fed is facing two simultaneous tracks: a short-term one dealing with inflation uncertainties caused by energy shocks, and a long-term one involving redesigning monetary policy operational frameworks, including bank reserve requirements and balance sheet size. This “dual-track” approach suggests future policy paths may become more complex.

Cook: Iran conflict raises inflation risk, policy trade-offs clearly shift

Fed Governor Cook, speaking in Connecticut, openly stated that the current risk balance has changed, with inflation now posing a higher risk than employment. During the Q&A after her speech, she said:

“I believe that, influenced by the Iran war, the current inflation risk is becoming higher. As for the labor market, I think it is currently balanced, but this is a fragile balance.”

She pointed out that the energy price shocks from the Iran conflict, combined with previous tariff factors, are intensifying the pressure for inflation to deviate from the 2% target. Media quoted her post-event comments, saying she believes the inflation risk “may last longer than expected,” implying policymakers cannot afford to relax vigilance easily.

In contrast, Cook’s assessment of the labor market is more cautious but still balanced. She believes the overall labor market is “balanced, but this balance is fragile.” Data shows U.S. job growth has continued to slow, with hiring momentum weakening, but no clear deterioration has yet emerged.

In terms of policy implications, this assessment means the Fed will rely more on data for its rate path and remain highly sensitive to upside inflation risks. Especially amid oil price shocks, policymakers might prefer to “stay the course” rather than hastily easing.

Mester: Balance sheet reduction may take years, potentially cut $1-2 trillion

Unlike Cook’s focus on short-term inflation, Mester emphasizes the long-term adjustment of the Fed’s balance sheet.

In her latest speech and working paper, she stated that the Fed is fully capable of significantly reducing its current roughly $6.7 trillion balance sheet, but this process “likely will take several years” and must be phased in.

Mester estimates that under the current operational framework, if the Fed can reduce bank reserve requirements, the balance sheet could shrink by $1 trillion to $2 trillion. However, she stressed that this premise itself requires policy adjustments, such as:

• Relaxing regulatory requirements like the Liquidity Coverage Ratio (LCR)
• Removing the “stigma” associated with using discount windows and standing repo facilities
• Conducting more active open market operations at key times like quarter-ends
• Enhancing liquidity appeal of alternative assets like government bonds

She explicitly stated that “before these preparatory measures are in place, truly starting balance sheet reduction will still be some time away.”

“Slow is fast”: balance sheet reduction must coordinate with rate policy to avoid market shocks

Mester particularly emphasized that the balance sheet reduction must be “very slow” to give financial markets time to adapt. She straightforwardly said, “It’s hard to overstate the importance of proceeding cautiously.”

More critically, she pointed out that shrinking the balance sheet itself has a tightening effect, which might require “more rate cuts than the baseline scenario” to offset. This suggests that future policy combinations could involve “balance sheet reduction + rate cuts” in parallel.

On a systemic level, she also warned that if the Fed reverts to the “scarcity of reserves” system used before the financial crisis, it would inevitably lead to increased short-term interest rate volatility.

Regarding the ultimate target size, Mester considers returning to pre-financial crisis levels “unrealistic,” but suggests controlling the balance sheet at about 15%-18% of GDP (pre-pandemic levels), whereas current levels remain above 20%.