Federal Reserve Balance Sheet Reduction: How Significant Is the Impact?

The future approach of the Federal Reserve in reducing its balance sheet is becoming a focal point of market attention. In its latest research report, Morgan Stanley points out that compared to policy interest rate adjustments, changes in the balance sheet size may have more profound effects, but the entire process will be very slow and there are many technical constraints and market trade-offs.

The report states that the current balance sheet reduction mainly relies on "passive reduction," meaning simply allowing held U.S. Treasury bonds and mortgage-backed securities to mature without reinvesting. This method has reduced the Fed's assets by over $2 trillion since 2022 and will likely remain the primary path going forward. However, as reverse repo tools are nearly exhausted, further balance sheet reduction will increasingly directly decrease bank reserves, which will have a more pronounced impact on financial system liquidity.

The most pressing concern for the market is whether balance sheet reduction will push up interest rates. Morgan Stanley’s judgment: Not necessarily. The key lies in how the U.S. Treasury issues new debt. If more issuance is done through short-term Treasury bills rather than by increasing long-term coupon bond issuance, the upward pressure on long-term rates may be limited.

Two Paths to Balance Sheet Reduction: Passive Maturity and Active Sales

The report points out that the Federal Reserve mainly has two ways to reduce the balance sheet: One is passive reduction, not reinvesting securities when they mature; the other is actively selling assets in the market.

Currently, passive reduction remains the most realistic path. Actively selling assets, especially MBS, is difficult, as it could widen spreads and further worsen housing affordability. Thus, the Fed’s threshold for actively selling MBS is very high.

At the current pace, it may take nearly ten years for the Fed’s holdings of MBS to be cut in half, indicating the reduction process itself will be very slow.

The Real Constraint: Bank Reserves and Liquidity

The key limitation for further reduction lies not on the asset side, but on the liability side.

As reverse repo amounts decline, future balance sheet reduction will increasingly rely on the reduction of bank reserves. But banks have a strong demand for reserves, such as regulatory requirements for liquidity coverage ratio (LCR), and internal liquidity management rules.

If reserves decline significantly, liquidity conditions in funding markets may tighten, the volatility of the federal funds rate and repo rates may rise, and may even exceed the reserve rate. To prevent substantial volatility in market rates, the Federal Reserve may need to use more temporary open market operations to adjust liquidity.

A Technical Approach: Reducing the Balance Sheet Without Cutting Reserves

The report also proposes a technical possibility: reducing the balance sheet through coordination between the Treasury and the Fed without decreasing bank reserves.

For example, the Treasury could lower its balance in the Treasury General Account (TGA) at the Fed. If the TGA shrinks, the Fed can reduce its holdings of Treasury bonds to a corresponding extent, thereby shrinking its balance sheet without changing the level of reserves in the banking system.

This approach may also lower the interest expense the Treasury pays to the Fed, but would require a high degree of policy coordination.

Will Balance Sheet Reduction Push Up Long-Term Rates? The Key Is the Treasury

The market generally worries that balance sheet reduction means increased bond supply, pushing up yields, especially long-term rates. But the report argues that this relationship is not inevitable.

If the reduction happens via passive maturity, the additional supply is actually completed through Treasury refinancing, and the maturity structure of Treasuries is determined by the Treasury, not the Fed.

If the Treasury continues to prefer issuing short-term bills rather than expanding long-term bond issuance, the long-term bond supply the market needs to absorb will not rise significantly, and therefore upward pressure on long-term rates may remain limited.

Overall, balance sheet reduction by the Fed is technically entirely feasible, but the process will advance slowly and be constrained by bank reserve demand, market liquidity, and the Treasury's debt issuance structure. For the market, what’s truly worth monitoring is not just the reduction itself, but the changes in liquidity conditions and rate structure during the process.

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