Federal Reserve Governor: Iran war makes inflation risk outweigh employment, balance sheet reduction may take years

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As the situation in the Middle East and the inflation outlook become intertwined once again, two Federal Reserve Governors spoke out on Thursday, the 26th Eastern Time, releasing subtle but key policy signals. Among them, Governor Cook explicitly pointed out that the Iran conflict has made inflation risks once again outweigh employment. Governor Milan, on the other hand, directed the discussion toward the longer-term policy framework—emphasizing that balance sheet reduction will be a gradual process "measured in years."

Overall, the Federal Reserve is simultaneously facing two main threads: in the short term, it must deal with inflation uncertainty caused by energy shocks; in the long term, it needs to redesign its operational framework for monetary policy, including the demand for bank reserves and the size of the balance sheet. This “two-front battle” means the future policy path may become more complex.

Cook: Iran conflict drives up inflation risk, policy focus has clearly shifted

Federal Reserve Governor Cook, in a speech in Connecticut, stated bluntly that the current risk balance has changed. Compared to employment risks, inflation risks are now higher. In the Q&A after the speech, Cook said:

“I believe, affected by the war with Iran, current inflation risks are becoming higher. As for the labor market, I think it is currently balanced, but this balance is precarious.”

She pointed out that the energy price shocks caused by the Iran war, combined with previous tariff factors, are intensifying the pressure for inflation to stray from the 2% target. Media quoted her after the meeting as saying she believes inflation risk “may persist longer than expected,” meaning policymakers cannot easily let down their guard.

In contrast, Cook’s assessment of the job market is more cautious but still balanced. She believes the labor market is generally in a “balanced state, but the balance is fragile.” Data shows U.S. job growth has continued to slow, hiring momentum is insufficient, but significant deterioration has not yet occurred.

Policy-wise, this judgment means the Fed will be more data-dependent on rate path decisions while remaining highly sensitive to upside inflation risks. Especially against the backdrop of rising oil prices, policymakers may lean towards “holding steady” rather than abruptly shifting toward easing.

Milan: Balance sheet reduction may take years, with up to $1–2 trillion in assets cut

Unlike Cook’s focus on short-term inflation, Governor Milan puts the emphasis on the long-term adjustment of the Fed’s balance sheet.

In his latest speech and working paper, he indicated the Fed is fully capable of significantly reducing its current $6.7 trillion balance sheet, but this process “will likely take years” and must be carried out in stages.

Milan estimates that under the current operational framework, if banks’ demand for reserves can be reduced, the Fed’s assets could shrink by $1–2 trillion. However, he stressed that this premise itself requires policy adjustments, such as:

• Relaxing regulatory requirements like the liquidity coverage ratio (LCR)
• Eliminating the “stigma” attached to banks’ use of the discount window and standing repo facility
• Conducting open market operations more actively at key times like quarter-end
• Enhancing the liquidity appeal of alternative assets such as Treasuries

He made it clear that until these preparatory measures are completed, “it will still take some time before real balance sheet reduction begins.”

“Slow is fast”: Balance sheet reduction must cooperate with rate policy to avoid market shocks

Milan especially emphasized that the balance sheet reduction must be “very slow” so that financial markets have time to adapt. He said bluntly: “It’s hard to overstate the importance of proceeding slowly.”

More importantly, he pointed out that shrinking the balance sheet itself has a tightening effect, so it may be necessary to “cut rates more than in the baseline scenario” to offset that. This means, in the future, a “balance sheet reduction plus rate cuts” combination may appear.

Institutionally, he also warned that if the Fed returns to the “scarce reserves” system before the financial crisis, there will inevitably be an increased cost of rising short-term interest rate volatility.

Regarding the eventual target size, Milan thinks returning to pre-crisis levels is “unrealistic,” but it is possible to control the balance sheet at around 15%-18% of GDP (pre-pandemic levels), while the current ratio is still above 20%.

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