A former senior economist at the Federal Reserve has highlighted that the process of reducing the central bank's balance sheet could impose significant structural pressures on financial markets, marking a critical area for current focus.

On Wednesday the 17th, the first policy decision meeting under the new Federal Reserve Chair, Wash, was convened.

Multiple institutions maintain their view that the Fed will neither cut nor raise interest rates within the year. They also predict the central bank might "demonstrate resolve by reinforcing expectations for balance sheet reduction rather than hinting at rate hikes." A scenario of "balance sheet reduction proceeding first, with rate cuts delayed" cannot be ruled out.

How will the policy combination of "balance sheet reduction and interest rate cuts" proposed by Chair Wash operate in practice? What impact might it have on financial markets?

Hu Jie, a former senior economist at the Federal Reserve and a professor at the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University, explained in an interview that the Fed typically employs two fundamental strategies in its monetary control. He described these as the "left-hand strategy" and the "right-hand strategy." The left-hand strategy involves directly controlling the size of the Fed's own balance sheet (i.e., expansion or reduction). The right-hand strategy involves adjusting the benchmark interest rate and other tools to influence commercial banks' lending willingness and credit scale, thereby regulating the associated level of derivative deposits.

He elaborated, "Chair Wash believes the Fed's left-hand strategy should be exercised with restraint and return to a more conventional state."

Professor Hu further cautioned, "It is crucial to emphasize that the balance sheet reduction process itself can generate substantial structural shocks to financial markets. This is the most pressing issue requiring attention at present."

The Fed's Dual Tools

The core statutory mandate of the Federal Reserve, established by the Federal Reserve Act of 1913 and subsequent amendments, primarily consists of two objectives: maximizing employment and maintaining price stability. These goals are often summarized as the "dual mandate."

Professor Hu stated that the Fed fulfills its mandate by issuing an appropriate amount of currency to ensure the stable operation of the overall economy.

"In practical terms, 'appropriate' refers to maintaining basic price stability, keeping the U.S. inflation rate around 2%. Once this level is achieved, it signifies the Fed has met its key performance indicator," Professor Hu noted.

Against this backdrop, the Fed in its monetary control typically utilizes the aforementioned two sets of tools: the "left-hand strategy" and the "right-hand strategy."

He explained that the so-called "left-hand strategy" refers to the Fed directly controlling the total amount of currency it issues, known in economics as base money/central bank money. "The issuance and withdrawal of central bank money depend entirely on Federal Reserve decisions. If a meeting decides to issue more, the amount increases, and vice versa."

Taking March 2020 as an example, the Federal Open Market Committee (FOMC) swiftly made decisions following the crisis. Within a mere three months, it dramatically increased the base money it issued from $4 trillion to $8 trillion. How was this additional $4 trillion created and injected into the market?

"Simply put, the Fed recorded $4 trillion simultaneously on both the asset side (left) and liability side (right) of its own balance sheet. Although the $4 trillion on the liability side is debt, as the sovereign issuer of fiat currency, it is not obligated to repay principal or interest to anyone. After establishing the $4 trillion position on the asset side, the Fed injected this massive sum into the financial system by purchasing assets such as U.S. Treasury bonds on a large scale," he explained. "This process is what is commonly known as quantitative easing (QE)."

"The direct result was that the Fed, on one hand, created and injected $4 trillion into the real and financial networks, while on the other hand, the size of its own balance sheet expanded from $4 trillion to $8 trillion. This is 'balance sheet expansion.' Conversely, if the Fed sells assets it holds, withdraws currency from the market, and cancels it, this quantitative tightening (QT) process constitutes 'balance sheet reduction,'" he stated.

Regarding the logic of the "right-hand strategy," it can be observed that after the $8 trillion in central bank money enters the economy, the vast majority ultimately circulates and settles within the commercial banking system.

"Suppose a commercial bank holds $100 million in central bank money (reserves). That bank is not limited to lending out only $100 million. When a borrower comes for a loan, the bank can extend a $400 million loan, thereby generating $400 million in associated deposits," Professor Hu explained. This newly created $400 million in deposits is termed "derivative money" in economics. Originally, this money did not exist. Because the central bank issued $100 million in base money, commercial banks, through lending activities, created $400 million in deposits, which the market treats as money. Ultimately, this $400 million in derivative money plus the initial $100 million in base money constitutes $500 million in broad money (M2).

In short, the Fed's "right-hand strategy" involves adjusting tools like the benchmark interest rate to influence commercial banks' willingness to lend and their credit scale, thereby regulating the associated level of derivative deposits.

Professor Hu said, "The Fed coordinates its 'two hands,' aiming ultimately to lock the inflation rate at the desired level of 2%. Logically speaking, as long as the coordination between the left and right hands is appropriate, the goal of controlling inflation can largely be achieved. However, different Fed chairs exhibit significant differences in operational style and strategic preference."

Balance Sheet Reduction Process Poses Risks to Markets

Professor Hu explained that before the 2008 financial crisis, the Fed's left-hand strategy saw relatively little turbulence.

"The balance sheet at that time was very stable, basically maintaining single-digit growth in sync with the size of the economy. On a chart, the balance sheet curve for that period appears as an extremely gently sloping straight line. But after 2008, due to drastic changes in the macroeconomic environment, the quantitative easing left-hand strategy was brought to the forefront," he stated. "During former Chair Bernanke's tenure, the Fed successively launched three rounds of QE; thereafter, it remained largely stable during Yellen's period; entering the Powell era, the Fed initiated another epic round of QE. From 2008 to the present, the Fed has undergone four large-scale expansions of base money."

Apart from the first round of quantitative easing, Chair Wash has been critical of the subsequent three rounds, arguing that QE during non-crisis periods distorted market pricing, kept long-term interest rates artificially low for extended periods, and led to inflated stock market valuations, among other issues.

Professor Hu also noted that Chair Wash's core philosophy differs substantially from that of his predecessors.

"Chair Wash believes the Fed's left-hand strategy should be exercised with restraint and return to a more conventional state," Professor Hu stated. Wash tends to believe that the accumulated stock of base money from policies over many years is excessively large. Therefore, he advocates for steadily and predictably advancing balance sheet reduction, aiming to genuinely streamline the Fed's balance sheet size to a level he deems reasonable and then stabilize it.

He explained that while stabilizing the "left hand," barring external geopolitical shocks such as conflict in the Middle East, Wash is more inclined to use the "right hand" for fine-tuning interest rates, thus forming a paradigm where "balance sheet reduction and interest rate cuts" proceed simultaneously. Of course, regardless of the specific operational combination, the Fed's ultimate goal remains controlling inflation at a low and stable level around 2%.

However, Professor Hu pointed out that before 2008, the proportion of money allocated to financial institutions and asset markets within the overall societal liquidity distribution was relatively limited. "After Bernanke initiated quantitative easing operations in 2008, the control paradigm underwent a fundamental reversal. A massive amount of base money was directly injected into and retained by financial institutions. This change in operational mode has significantly driven up asset prices in financial markets over the past decade and more."

He stated, "The data comparison is very直观: Before 2008, the average annual return rate of the U.S. stock market was approximately 6.6%; after 2008, this figure surged significantly to 11.2%. This dramatic difference in returns is largely driven by the Federal Reserve's quantitative easing control paradigm."

Professor Hu warned, "If Chair Wash implements his理念 in the future, reversing the aforementioned operational paradigm—that is, steadfastly推进 balance sheet reduction—the proportion of high-frequency money held by financial institutions is bound to gradually decline. This implies that various asset prices in financial markets will face systematic downward valuation pressure in the future."