Balance Sheet Reduction and Interest Rate Cuts Both Face Obstacles: The Dilemma Confronting Waller Upon Taking Office

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The next Federal Reserve Chair, Walsh, won the nomination with two major policy agendas: interest rate cuts and balance sheet reduction. However, the economic environment he is about to inherit is simultaneously undermining the feasibility of both objectives.

The unexpected rebound in inflation has significantly cooled the Fed's internal willingness to cut rates, while the resilience of the labor market has also lessened the urgency for easing policies. Currently, average futures market pricing shows traders do not expect any rate cuts in 2026.

Meanwhile, on the issue of reducing the balance sheet, the Fed has previous experience indicating that even gradual balance sheet reduction may trigger volatility in the bond market, making the process arduous.

Walsh has been confirmed by the Senate on party-line votes, but the exact timing of his official swearing-in remains unclear. What he inherits is a monetary policy environment that visibly diverges from his envisioned agenda.

Inflation Pressure and Labor Market Resilience: The Window for Rate Cuts Has Narrowed

When Walsh was nominated this January, most of his future colleagues still regarded rate cuts as a matter of timing. However, this backdrop rapidly shifted.

The outbreak of war in Iran at the end of February drove energy prices sharply higher, pushing overall inflation upward. This has made any central bank's decision to cut rates increasingly difficult. Both the European Central Bank and the Bank of England have warned they may turn to rate hikes this year.

At his Senate confirmation hearing, Walsh hinted he might push for the Fed to reference alternative, relatively mild inflation metrics. But in the current environment, whether this strategy will gain majority support in the committee remains uncertain.

The trend in the labor market has further weakened the grounds for easing policies.

A weak employment report in February temporarily heightened market concerns about rising unemployment, but subsequent reports for March and April showed the labor market had not lost momentum and the unemployment rate remains low.

Walsh previously advocated for rate cuts by citing productivity boosts brought by artificial intelligence. However, in the current inflation environment, this argument is much less persuasive.

Balance Sheet Reduction Dilemma: Extremely Limited Room for Maneuver

Walsh has long criticized the Fed’s balance sheet for being overly large. The Fed conducted large-scale balance sheet expansion during the 2008-2009 financial crisis and the pandemic, with asset size approaching $9 trillion at its 2022 peak, and now around $6.7 trillion.

Reducing asset size must also compress the liability side, and the Fed's liabilities are crucial for the stable operation of the economy.

Among the Fed's main liabilities, Treasury deposits in the Fed's checking account and physical cash are essentially beyond the Fed’s direct control; the overnight reverse repo tool—once over $2 trillion—has nearly returned to zero in the previous round of balance sheet reduction.

This leaves bank reserves as the only space that can materially be compressed. The Fed has complete control over the supply of reserves, and most balance sheet reduction plans target this liability item.

However, last autumn’s experience clearly revealed its fragility: even a moderate decrease in reserves triggered strong anxiety in the bond market, and the Fed was forced to quickly reverse course and re-expand reserves. This means that Walsh’s balance sheet reduction plan faces not only internal policy disagreement, but also unpredictable market risks.

Internal Disagreement: Consensus Is Hard to Sustain

Leading the Fed means forging consensus among eleven other officials who also have voting rights on interest rates. If Walsh pushes for rate cuts or balance sheet reduction, he will likely encounter resistance from his new colleagues, including the outgoing chair Powell.

During most of Powell's term, committee decisions were made by consensus. But over the past year, divergences within the voting committee have become pronounced.

At the most recent meeting held at the end of April, the Fed held rates steady, but four officials cast dissenting votes. Three of them believed the Fed should begin signaling the equal possibility of both rate hikes and cuts.

At the Fed’s quarterly rate path forecasts, the median in March was for one rate cut this year and another next year. This forecast will be updated at next month's meeting.

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