Is the Fed going to shrink its balance sheet? Bank of America: It’s probably just "much ado about nothing."

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The market’s concerns about new Fed Chairman Kevin Warsh’s aggressive balance sheet reduction may be greatly overestimating what he can actually achieve.

Warsh was recently officially confirmed by the Senate as Fed Chairman. Because he has long held a critical stance toward the Fed’s large balance sheet, the market generally fears he will push for rapid and large-scale balance sheet reduction. However, Bank of America rate strategists Mark Cabana and Katie Craig bluntly state in their latest research report released May 18: From both a scale and composition perspective, the space Warsh can genuinely move is extremely limited, and the direct impact on the market is expected to be close to zero.

The core of Bank of America’s judgment is this: regarding the size of the balance sheet, the Fed has already completed normalization of quantitative tightening by Q4 2025. Further shrinking would require reducing currency, the Treasury General Account (TGA), or reserves—of which Warsh can only materially affect reserves, with limited pathways and a slow pace.

Regarding asset composition, the MBS reinvestment plan is already underway and fully priced in by the market; the impact of shortening the weighted average maturity (WAM) of Treasuries is effectively neutralized by market mechanisms. Neither constitutes a tightening of financial conditions nor triggers a rate cut signal.

The report also raises a scenario not yet mainstream in the market’s attention: if the Standing Repo Facility rate (SRP) is set equal to the Interest on Reserve rate (IOR), combined with reduced disclosure requirements to lessen the "stigmatization" effect, it could more effectively reduce banks’ reserve demand, thereby creating real operational space for a balance sheet reduction. Bank of America believes the real impact of this plan could exceed conventional expectations for Warsh's approach to balance sheet reduction.

Constraints of Scale: Only Reserves Are Truly Adjustable Among Three Core Liabilities

After the Fed’s balance sheet completes quantitative tightening normalization, the total size is around $6.78 trillion, driven by the liability side. The three main core liabilities are: reserves ($3.12 trillion, 46%), currency ($2.46 trillion, 36%), and TGA ($807 billion, 12%).

Currency is regarded by the central bank as an "exogenous" liability, beyond policy tool reach. Bank of America notes that theoratically, large denomination banknotes could be canceled to reduce it, but "this will not happen in the United States."

Regarding TGA, the Treasury has clearly expressed no intention to compress it. TGA is expected to rise to $900 billion by the end of Q2 2025 and further to $950 billion by Q3 2025.

Bank of America believes marginal adjustments via TGA through repo investment are possible but negligible; adjustments via the Treasury Tax and Loan Accounts (TT&L) channel are "extremely unlikely."

Reserves are the most realistic option for Warsh to reduce the balance sheet, but each pathway is constrained.

The "bank-unfriendly" method—setting a reserve cap or tiered interest—would compress bank liquidity, weaken market making and lending willingness, thereby dragging down the economy. Bank of America believes Warsh is unlikely to adopt this.

The "bank-friendly" pathway is to relax regulation, allow banks to pre-pledge collateral to the discount window to expand high-quality liquid assets (HQLA), thereby reducing demand for reserves.

Bank of America estimates this pathway could ultimately bring about a $200–$500 billion reduction in reserves, but the process would be slow and, as it wouldn’t tighten financial conditions, would not constitute grounds for a rate cut.

Composition Adjustment: WAM Compression Impact Nullified by Countervailing Mechanisms

Warsh’s room to operate on the asset composition side is likewise constrained by mechanisms.

The Fed currently holds about $1.98 trillion in MBS, and is gradually compressing this at a pace of $10–$20 billion per month by letting MBS mature or be prepaid, then reinvesting into Treasuries.

Bank of America believes the likelihood of selling MBS is very low (unless Fannie Mae or Freddie Mac directly repurchase, considered improbable), and the current approach is fully priced in by the market, not cause for new disturbance.

Shortening the weighted average maturity (WAM) of Treasuries is another focus.

Warsh may change the reinvestment of maturing Treasury coupons from the current proportional allocation across maturities, to concentrate investment in short-end (e.g., 2–3-year Treasuries) to accelerate WAM compression. However, the Fed’s reinvestment uses an "add-on" auction model—participating in auctions in an additive manner, directly increasing short-term Treasury stock rather than replacing long-term ones.

This raises a key question: will the Treasury adjust its debt issuance structure to offset the Fed’s WAM shortening impact? Bank of America’s answer is no. If this judgment holds, the Fed’s WAM compression will have zero actual impact on the overall Treasury market and financial conditions, and Warsh would have no logic for pushing rate cuts on this basis.

Ample Reserves: Warsh Has No Will Nor Capability to Change

In Bank of America’s view, the most critical question regarding Warsh is: will he support an "ample" or "scarce" reserve regime? Bank of America’s answer: ample, and with extreme certainty.

The advantages of an ample reserve regime are easy execution, ensuring bank system liquidity, curbing money market volatility, and supporting relatively loose financial conditions, at the cost of a slightly larger balance sheet. In contrast, a scarce regime could further compress the balance sheet, but would bring real risks like increased money market volatility and liquidity stress.

Bank of America gives two supports. First, Trump values loose financial conditions far more than the Fed’s balance sheet size, and Warsh is expected to be open toward these policy preferences.

Second, the Fed officially adopted an ample reserve regime in 2019, and the entire current leadership supports it; some officials are particularly clear—Bank of America cites Fed Governor Waller’s February 2026 speech: "You don’t want banks digging for money under the sofa cushions every night... That’s extremely inefficient and extremely stupid." Bank of America’s report specifically highlighted the final word.

Bank of America believes Warsh is not only subjectively inclined toward the ample regime, but objectively will be bound by internal Fed consensus.

SRP=IOR Mechanism May Be the Real Solution

Bank of America proposes in its report a mechanism beyond the traditional framework, based on comments from Dallas Fed President Logan: set the Standing Repo Facility rate (SRP) equal to the Interest on Reserves rate (IOR).

The design is this: banks can post Treasuries or agency debt as collateral at any time at a price equal to their deposit rate, to obtain cash from the Fed; the operation is like the discount window, but open all day without discrete operation windows.

Because the rate is competitive and carries no premium, banks are more willing to use it, their demand for precautionary reserve buffers falls, creating operational space for the Fed to reduce its balance sheet. The Bank of England currently uses a similar mechanism.

To further unleash effectiveness, Bank of America recommends reforming information disclosure, specifically canceling the weekly report on reserve distribution by region. This report is currently used by market participants to track institutions that may face liquidity stress; canceling it can effectively reduce the "stigmatization" of using the SRP tool, making banks more willing to use it as needed instead of hoarding excess reserves.

The report also states that bank SRP and dealer SRP should be distinguished: dealer SRP rates should be 5–10 basis points higher than bank SRP, ensuring banks are willing to lend in the repo market while leaving pricing room for free market trading.

Bank of America concludes, "'Bank SRP=IOR' plus disclosure reform could substantially lower bank reserve demand, providing Warsh a genuinely viable balance sheet reduction path. This plan is not yet mainstream in the market discussion, but Bank of America expects it will eventually draw widespread attention—its impact may far exceed traditional estimates of Warsh’s capacity for balance sheet reduction."

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