Deep Dive into the Federal Reserve’s Major “Balance Sheet Reduction” Paper: How Much to Reduce, How to Reduce, What Are the Impacts?

At 10 pm Beijing time on Tuesday, the U.S. Senate Banking Committee will hold a hearing on the nomination of Kevin Walsh as Chairman of the Federal Reserve. This is Walsh's first formal occasion on Capitol Hill to systematically outline his monetary policy positions. Notably, Walsh has long held a critical stance towards the large scale of the Fed's balance sheet, and this hearing may be an important window for expressing his relevant views.

In fact, since the end of 2025, the trajectory of the Fed's balance sheet has remained a core issue of high concern in global financial markets. Against this backdrop, Fed Governor Stephen Milan, together with three Fed economists, recently released a working paper titled "A User's Guide to Reducing the Federal Reserve Balance Sheet," and systematically explained the strategic logic and possible pathways of balance sheet reduction during a thematic speech at the Miami Economic Club on March 26, 2026.

The core value of this paper lies in breaking the conventional market perception. In the past, the market generally believed that "the ceiling for the Fed’s balance sheet reduction is the depletion of reserves." But the paper points out that the demand for reserves can itself be shaped by policy—through a series of adjustments to regulatory and operational frameworks, the Fed can very well achieve significant balance sheet reduction while maintaining a "sufficient reserves" framework.

In response, CITIC Securities’ research team conducted in-depth analysis. Their judgment is: relaxing LCR standards, reforming SRP, and upgrading Fedwire technical options are relatively feasible; but reserve layering, reforming TGA and foreign reverse repo pool proposals are relatively idealistic. Overall, the balance sheet reduction process is unlikely to change the fundamental logic of global central bank gold purchases, and CITIC Securities maintains its expectation for a 25 basis-point rate cut by the Fed in the second half of this year.

Why Reduce the Balance Sheet: Milan’s List of Reasons

In his Miami speech, Milan directly laid out multiple reasons for reducing the Fed's balance sheet.

First, to reduce market distortions. An overly large Fed balance sheet causes unnecessary intervention in the funding markets, exacerbating the disintermediation problem of financial intermediaries. Minimizing the Fed's "footprint" in the market is fundamental to maintaining price discovery.

Second, to control financial risk. Large asset holdings mean greater exposure to market value losses and increased volatility in remitting profits to the Treasury. The Fed has recently faced mark-to-market losses due to holding large amounts of long-term securities—this issue can no longer be ignored.

Third, to guard the boundary between monetary and fiscal policy. A huge balance sheet objectively puts the Fed in the position of allocating credit resources, blurring the boundary between monetary and fiscal policy. In addition, paying large-scale reserve interest to banks is seen by some members of Congress as a hidden subsidy to financial institutions.

Fourth, to preserve policy ammunition. If another zero lower bound crisis arises, the Fed will need to expand its balance sheet again to provide accommodation. Compressing the balance sheet to a reasonable size now is necessary to reserve flexibility for future policy.

Milan admits that the public widely believes large-scale balance sheet reduction is "basically impossible." But his judgment is completely different: "Reducing the balance sheet is a solvable challenge; those who outright deny it just lack imagination."

Key Diagnosis: The Constraint on Balance Sheet Reduction Is “Demand,” Not “Supply”

To understand this discussion, one must first clarify a logic structure long misinterpreted.

The traditional framework holds that the constraint on Fed balance sheet reduction comes from "reserve supply hitting the steep section of the demand curve"—once supply tightens to the critical point, the overnight rate loses control. Thus, the Fed can only stop balance sheet reduction passively when reserves fall to a "scarce" status. The "repo market shock" of September 2019 is a real-life example of this logic.

The breakthrough of the paper is shifting focus from the “supply side” to the “demand side.” The paper argues that reserve demand is not an exogenous constraint determined by payment settlement activity, but is artificially elevated by regulatory rules, supervisory preferences, and the Fed’s operational framework—Milan refers to this as “regulatory dominance” over the Fed’s balance sheet.

Specifically, the following three mechanisms together elevate the baseline for reserve demand:

1. Spread makes reserves “easy money assets.” Since the Fed started paying interest on reserves in 2008, reserves transformed from a pure settlement necessity to assets competitive with Treasury bills. At times, the reserve interest rate (IORB) exceeded 1-month/3-month Treasury yields, leading banks to prefer hoarding reserves for risk-return reasons.

2. Multiple liquidity regulations create a “ratchet effect.” Rules like LCR (Liquidity Coverage Ratio), ILST (Internal Liquidity Stress Testing), Resolution Liquidity Expectation (RLEN), NSFR (Net Stable Funding Ratio), and SLR (Supplemental Leverage Ratio) are intertwined, resulting in a predicament—changing one rule means another rapidly becomes the binding constraint.

3. Discount window is long “stigmatized.” Due to its relatively high rate, historical association with “problem banks,” and exposure risk from usage records, banks prefer hoarding reserves to using policy tools during stress periods. The same stigma logic extends to the Standing Repo Facility (SRP).

This diagnosis reveals a fundamental policy path: instead of waiting for reserves to become scarce, policymakers can lower the “scarce—sufficient” dividing line so that the “sufficient reserves” framework can operate properly at a more modest balance sheet size.

How Much Could be Reduced: Quantitative Estimate of $1.2 Trillion to $2.1 Trillion

The paper uses the Fed’s H.4.1 data as of March 11, 2026 as a baseline: Total assets about $6.646 trillion. Liability side breakdown: reserves about $3.073 trillion, currency in circulation $2.39 trillion, Treasury General Account (TGA) about $806 billion, foreign reverse repo pool about $325 billion.

The paper quantifies two main directions and a total of 15 policy options, but most importantly avoids simply summing them. Because policy options are correlated and substitutive, the paper uses a Monte Carlo aggregation method under OMB A-4 framework, arriving at the following confidence intervals:

Milan in his speech compared the above range with historical benchmarks:

• 15% of GDP: The balance sheet level after the end of QE1 in 2009; the banking system was still functioning normally then;
• 18% of GDP (2012 or 2019 levels): Reflects genuine liquidity demand after Basel reforms and Dodd–Frank requirements became clear.

Currently, the Fed’s balance sheet is about 21% of GDP. Based on the paper’s median estimate, if reforms proceed smoothly, the balance sheet could fall back to a level close to 2012 or 2019. As for the possibility of returning to pre-crisis sub-10% of GDP—Milan is clear: “It’s unrealistic, and unnecessary.”

How to Reduce It: Menu Analysis of 15 Options

The paper splits its 15 policy tools into two categories, offering effect ranges and execution prerequisites for each.

First Category: Lowering Equilibrium Reserve Demand

(1) Regulatory Reform

• LCR reform: The key measure is allowing banks to count the lending capacity of loans pre-pledged to the discount window as HQLA (high-quality liquid assets), with a cap. The paper estimates the impact on reserve demand to be $50B–$450B. If only LCR is changed, NSFR may immediately become the next constraint; this needs holistic consideration.
• ILST and Resolution Liquidity Expectation (RLEN): If regulators recognize discount window capacity and short-term liquidity sources, ILST reform could lower reserve demand by $50B–$200B; for RLEN, extending the usable window could mean a $0–$100B impact.

(2) Supervisory Approach

If banks over-hold reserves to cater to examiner preferences (i.e. T-bills and reserves are not “equally recognized”), the adjustment size is estimated at $25B–$50B. This doesn’t require law change, but merely a shift in supervision culture—though it’s still difficult.

(3) Lowering Reserve Holding Rewards

Permit Effective Federal Funds Rate (EFFR) to exceed IORB, breaking the current long-standing EFFR below IORB. The paper cites Lopez-Salido and Vissing-Jorgensen (2025): if “EFFR-IORB = +2bp” (similar to September 2019 stress), reserve demand could drop by $150B–$550B.

However, this has clear costs: volatility in overnight/ repo rates will spike, and markets may hoard for precaution, partly offsetting the decline. This requires supporting mechanisms like SRP and TOMO.

(4) Enhancing Substitute Assets’ Attractiveness

Includes upgrading Fedwire, improving Treasury market liquidity, advancing central clearing, etc., to make substitutes more competitive with reserves. These also help the private sector absorb securities released as the Fed reduces its balance sheet.

(5) Destigmatizing Fed Liquidity Tools

By eliminating concerns around the discount window, SRP, and daylight overdrafts, banks’ precautionary reserve demand can be reduced. This requires improvements in transparency, pricing, and regulatory communication.

Second Category: Directly Reducing Non-Reserve Liabilities

(1) TGA Management Realignment

Reduce Treasury’s cash buffer in Fed accounts from “about 5 days operating funds” to “about 2 days,” excess to be moved to the banking system (like historical TT&L). The estimated impact is $200B–$400B. But as bank deposits rise, banks’ reserve needs also rise, so effects are not 1:1.

(2) Lowering Foreign Reverse Repo Pool’s Appeal

Lower interest and set caps, encouraging foreign central banks and sovereign funds to move funds from Fed’s pool to the US Treasury market. Estimated impact $0–$100B, relatively limited and dependent on external cooperation.

Walsh’s Signal: From Technical Paper to Policy Expectation

Understanding this paper requires awareness of Fed personnel context. The market generally expects Walsh to become Fed Chair. Walsh has long criticized QE-era balance sheet expansion and advocates reduction.

This working paper led by Milan is viewed externally as a signal of the likely future policy direction in the “Walsh era.” CITIC Securities’ research notes that given Walsh’s position and the potential space suggested by the paper, the “Walsh era” Fed may indeed progressively explore renewed balance sheet reduction.

But both the paper and the speech repeatedly stress that speed and pace are the most important constraints in execution. Milan stated: "Once reform preparations begin, under the APA (Administrative Procedure Act), it could take more than a year, even several years." He pointed to SLR reform—nearly six years from temporary relaxation to formal regulations.

Thus, the Fed will not restart balance sheet reduction immediately just because this paper is published. More likely, it will start research with less controversial, technically feasible options, and provide forward guidance on the new mechanisms.

CITIC Interpretation: What’s Feasible, What’s Idealistic

CITIC Securities' research systematically assessed the real-world feasibility of the 15 options, arriving at the following core conclusions:

Options with Realistic Feasibility:

• Relaxing LCR standards: technical regulatory reform, relatively controllable variables, Fed has initiative;
• Reforming SRP: destigmatization is straightforward, doesn’t require external legislation;
• Upgrading Fedwire: infrastructure-level long-term improvement, clear direction;
• ILST supervisory approach change: some reforms can be advanced without legislation, just by shifting supervision culture.

More Radical or Externally Reliant Options:

• Tiered reserve interest: may trigger nonlinear reactions in banks, complex operation;
• TGA management reform: requires coordination between Treasury and the Fed, needs political consensus;
• Foreign reverse repo pool reduction: highly dependent on external willingness, effect less certain.

Overall, CITIC Securities sees this as “a menu of reforms worthy of reference and quite pragmatic,” though actual implementation will be much slower than the potential depicted in the paper, making it a directional guide rather than a near-term policy commitment.

Market Impact: Increased Volatility But No Change in Rate Cut Logic

For the bond market, balance sheet reduction means reduced base money, inevitably increasing the amount of US Treasuries the private sector needs to absorb. CITIC Securities believes this will amplify market volatility and elevate tail risks—even though some deregulatory measures (like SLR relaxation) help expand dealer capacity.

As for the pace, the paper clearly opposes accelerating reduction by selling securities outright, favoring letting securities mature and roll off naturally, while bolstering dealer and repo market absorption capacity. This objectively limits short-term shock.

CITIC Securities judges US Treasuries are currently better for trading opportunities, with short maturities preferred over long.

For the stock market, balance sheet reduction has a contractionary effect on the real economy via monetary supply and portfolio balance, but can be offset by lowering the federal funds rate. CITIC Securities views rate path adjustment as increasingly necessary if balance sheet reform advances, but sees limited direct link to current monetary policy rhythm. US equities may await a pullback window for better safety margins.

For the gold market, balance sheet reform is unlikely to alter the strategic logic for global central banks to increase gold holdings; this is driven more by geopolitical realignment and dollar reserve diversification. Gold remains valuable for medium- to long-term allocation.

Milan explicitly said that contractionary effects from balance sheet reduction can be offset by rate cuts, and “balance sheet reduction may broaden the federal funds rate cut compared with baseline scenarios.” CITIC Securities expects US CPI year-on-year to oscillate between 3.0%–3.5%, maintains a forecast for 25bps Fed rate cut in the second half of the year, and notes that balance sheet reform and rate cut decisions are not directly linked.

Disclaimer & Risk NoticeMarkets are risky; investments require caution. This article does not constitute personal investment advice, nor does it consider the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions herein are aligned with their circumstances. Investing based on this content is at your own risk.