The future approach of the Federal Reserve to reducing its balance sheet is becoming a central focus for market participants. A recent analysis from Morgan Stanley indicates that changes in the size of the balance sheet could have more profound effects than adjustments to the policy interest rate. However, the process is expected to be very gradual, constrained by technical factors and market trade-offs.
The report suggests the current reduction primarily relies on "passive runoff," whereby maturing Treasury and mortgage-backed securities are not reinvested. This method has already decreased the Fed's assets by over $2 trillion since 2022 and is likely to remain the primary path forward. As the reverse repo facility is largely depleted, further balance sheet reduction will more directly diminish bank reserves, potentially exerting a more noticeable influence on financial system liquidity.
A key market concern is whether this reduction will push interest rates higher. The analysis suggests this is not a certainty. The critical factor lies in how the U.S. Treasury finances new debt. If funding is skewed more towards short-term Treasury bills rather than an increase in long-term coupon-bearing securities, upward pressure on long-term interest rates may be contained.
The report outlines two primary methods for balance sheet reduction: passive runoff and active asset sales. Currently, passive runoff remains the most feasible path. Active sales, particularly of mortgage-backed securities, present significant challenges as they could widen spreads and further deteriorate housing affordability. Consequently, the threshold for the Fed to actively sell these assets is very high. At the current pace, it could take nearly a decade to halve the Fed's mortgage-backed securities holdings, underscoring the inherently slow nature of the process.
The true constraint lies not on the asset side but on the liability side of the balance sheet. As reverse repo balances decline, further shrinkage will increasingly depend on a reduction in bank reserves. However, banks have a strong inherent demand for reserves due to regulatory requirements like the Liquidity Coverage Ratio and internal liquidity management rules. A significant decline in reserves could tighten conditions in funding markets, potentially increasing volatility in the federal funds rate and repo rates. To prevent substantial market rate fluctuations, the Fed might need to rely more heavily on temporary open market operations to manage liquidity.
The analysis also presents a technical possibility: reducing the balance sheet without decreasing bank reserves through coordination between the Treasury and the Fed. For instance, the Treasury could reduce its Treasury General Account balance held at the Fed. A smaller account balance would allow the Fed to reduce its Treasury holdings proportionally, thereby shrinking its balance sheet while leaving bank system reserves unchanged. This approach could also lower the interest the Treasury pays to the Fed, though it would require a high degree of policy coordination.
Regarding the concern that balance sheet reduction increases bond supply and pushes up yields, particularly long-term rates, the report argues this relationship is not automatic. If reduction occurs via passive runoff, the new supply is effectively determined by the Treasury's refinancing decisions and its chosen debt maturity structure, not the Fed. If the Treasury maintains a preference for issuing short-term bills over expanding long-term debt issuance, the supply of long-term bonds needing market absorption would not increase significantly, thus limiting upward pressure on long-term rates.
Overall, while the technical feasibility of the Fed reducing its balance sheet is clear, the process is expected to proceed slowly, constrained by bank reserve demand, market liquidity conditions, and the Treasury's debt issuance strategy. For markets, the critical focus should extend beyond the reduction itself to the evolving liquidity environment and interest rate structure throughout the process.