Following Warsh's hawkish remarks, the market is now focused on interest rate hikes, with Morgan Stanley suggesting that balance sheet reduction is more likely.

Warsh reiterated the Federal Reserve's commitment to keeping inflation back to 2% in the mountains of Wyoming, prompting markets to price in further rate hikes . However, Morgan Stanley's chief global economist, Seth Carpenter, pointed out in a recent report that this reaction may have overlooked a key variable— balance sheet reduction.

Carpenter writes that Walsh's stance on interest rate hikes was unclear in July, only stating that rates "may be part of the solution." In Jackson Hole, however, he clarified his position: the policy rate is the "primary tool," and other tools should be used "as little as possible, or even not at all."

However, this does not mean that the reduction of the balance sheet will be shelved.

Warsh's logic: The balance sheet is the root cause of inflation.

Before becoming Chairman of the Federal Reserve, Warsh gave an interview at the Hoover Institution, where he offered a more candid explanation of the use of the two major policy tools.

According to Carpenter, Warsh explicitly argued that the $7 trillion balance sheet was the root cause of inflation exceeding the target. At Jackson Hole, he listed "money" as one of the core principles of monetary policy operations, further stating that if the "money" created by the balance sheet were withdrawn, interest rates could be kept at a lower level.

The logical chain is clear: balance sheet reduction → monetary tightening → inflation decline → reduced pressure to raise interest rates.

Internal divisions within the FOMC are widening, and pressure to raise interest rates is real.

Morgan Stanley's original baseline forecast was no rate hike this year, provided that inflation could fall moderately, leading the FOMC to abandon the option of raising rates.

However, Carpenter points out that the FOMC makes decisions by vote, and there are currently three dissenting votes in favor of raising interest rates. If summer inflation data fails to convincingly show that inflation is cooling, a rate hike will occur.

“Wash won’t put himself on the losing side of the vote,” Carpenter wrote.

This means that even if Warsh himself prefers to reduce his balance sheet instead of raising interest rates, he will follow suit if the majority of the committee favors raising interest rates.

Morgan Stanley predicts that the scale of balance sheet reduction next year may exceed $1.5 trillion.

Carpenter stated that he does believe balance sheet reduction is imminent. A recent report by Morgan Stanley ("Global Economy and Fixed Income Strategy: Fed Balance Sheet Reform: More Reduction, Less Tightening") predicts that the Fed may launch a balance sheet reduction program of $1.5 trillion or even larger next year.

Carpenter also admitted that his assessment of how quantitative tightening transmits to the economy and ultimately affects inflation differs significantly from Warsh's. However, regardless of the transmission path, the conclusion for the market is consistent:

When pricing monetary policy, investors must take both interest rates and balance sheets into account , which will bring additional uncertainty and controversy.

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