The Federal Reserve's meeting this week is set to focus on interest rate trends and the U.S. economic outlook—with a third rate cut this year highly anticipated. However, as the balance sheet reduction process officially concluded on December 1, updates on the Fed's asset portfolio arrangements may also emerge during this meeting.
In October, to address mounting pressures in the repo market, the Fed announced it would reinvest principal payments from maturing Treasury securities and mortgage-backed securities into short-term Treasury bills. Yet, this measure has not fully resolved the issue: overnight rates frequently breach the Fed's target range, and banks continue relying on the central bank's liquidity support tool—the Standing Repo Facility (SRF).
This signals that bank reserves—the safest and most liquid form of money in the financial system—are nearing the lower bound of the Fed's "ample" range. Under the current framework, this implies that even with nearly $6 trillion in Treasury and mortgage-backed securities held by the central bank, further expansion may soon be necessary.
Fed Governor Christopher Waller recently emphasized that such measures are critical for maintaining repo market stability and ensuring smooth monetary policy transmission. Bank of America predicts the Fed will announce a monthly "reserve management" bond purchase plan of around $45 billion at the conclusion of this week's meeting.
**The Balance Sheet Debate** Given these developments, an expansion of the Fed's balance sheet is widely seen as inevitable. However, the Monetary Policy Radar team suggests the future trajectory of the balance sheet may be more uncertain than many anticipate.
U.S. Treasury Secretary Bassett once likened quantitative easing to a "gain-of-function" monetary policy—expanding the Fed's influence while distorting economic effects. Although he has softened this stance amid recent repo market pressures, other concerns persist.
Reinout De Bock of UBS noted, "There's clear disagreement over what the ample reserves regime means for the Fed's balance sheet size. Further regulatory reforms also seem possible. I expect this debate to intensify next year under new leadership."
While no Fed official disputes the necessity of ample reserves—a post-financial crisis framework credited with enhancing financial stability—divisions exist over how to implement this policy, casting doubt on the inevitability of balance sheet expansion.
Dallas Fed President Lorie Logan has publicly advocated shifting from a federal funds rate target to a repo rate target. On reserves, she favors a more flexible approach to balance sheet expansion. "The size and timing of reserve management purchases shouldn’t be mechanical," she stated in November. "While purchases must offset predictable trends in money growth, reserve demand may also evolve due to economic shifts, banking changes, or regulatory adjustments."
**Path to a Smaller Balance Sheet** Logan's emphasis on regulatory adjustments is crucial. New Fed Governor Stephen Miran, a Trump appointee, argues the central bank should "minimize its footprint" in asset holdings. Though Miran's views are currently marginal and his tenure uncertain, his ties to the Trump administration and potential future Fed leadership mean his ideas may gain traction next year.
Miran contends that repo market stress reveals reserves nearing the "ample" floor—but blames bank regulations as the root cause, criticizing "regulation-driven" excess reserves. He highlights liquidity rules that force banks to hold Treasuries and reserves while requiring capital against these assets, creating "contradictory regulatory incentives" for primary dealers. Easing capital rules for Treasuries, he argues, would reduce reserve needs.
**Potential Regulatory Easing** Miran calls for excluding Treasuries and reserves from the Enhanced Supplementary Leverage Ratio (eSLR) entirely—a move the Fed temporarily adopted during the 2020 repo market crisis. Under Governor Michelle Bowman, efforts to relax these rules are advancing, allowing banks to hold more Treasuries without additional capital. New rules for large broker-dealer banks could free up $2.1 trillion in Treasury capacity, easing repo pressures and enabling lower reserve levels.
However, as noted in June, given soaring U.S. deficits and debt, such adjustments may only offer temporary relief. Opponents warn that exempting Treasuries from eSLR could heighten bank risks, and freed-up balance sheet space might fund non-Treasury activities. Under Chair Powell, such moves face stiff resistance. Next year, under new leadership, further easing could alleviate repo stress and align with the Trump administration's push for private-sector dominance—though at the risk of a more leveraged banking system.
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