A hearing on Kevin Warsh's nomination for Federal Reserve Chair will be held by the U.S. Senate Banking Committee at 10 PM Beijing Time on Tuesday. This marks Warsh's first official opportunity to systematically outline his monetary policy views before Congress. Notably, Warsh has long been critical of the Fed's large balance sheet, making this hearing a potential platform for his related arguments.
Since late 2025, the trajectory of the Federal Reserve's balance sheet has been a central focus for global financial markets. Against this backdrop, Fed Governor Stephen Milan, alongside three Fed economists, recently released a working paper titled "A User's Guide to Reducing the Federal Reserve's Balance Sheet." On March 26, 2026, during a speech at the Miami Economic Club, Milan systematically explained the strategic logic and potential pathways for the Fed's balance sheet reduction.
The core contribution of this paper lies in challenging conventional market wisdom. Previously, the market widely believed the "ceiling for Fed balance sheet reduction was the exhaustion of reserves." However, the paper argues that the demand for reserves itself can be shaped by policy—through adjustments to regulatory and operational frameworks, the Fed could significantly shrink its balance sheet while maintaining an "ample reserves" framework.
CITIC Securities Research Team subsequently provided an in-depth analysis. Their assessment is that technical options like easing LCR standards, reforming the Standing Repo Facility (SRF), and upgrading Fedwire possess practical feasibility. In contrast, proposals such as tiered reserve remuneration, reforming the Treasury General Account (TGA), and reducing the foreign reverse repo pool are more idealistic. Overall, the balance sheet reduction process is unlikely to alter the fundamental logic driving global central banks' gold purchases. CITIC Securities maintains its forecast for a 25-basis-point Fed rate cut in the second half of this year.
**Why Reduce the Balance Sheet: Milan's Rationale**
In his Miami speech, Milan directly presented multiple reasons for reducing the Fed's balance sheet. First, to reduce market distortions. An excessively large Fed balance sheet creates unnecessary intervention in funding markets, exacerbating financial disintermediation. Minimizing the Fed's "footprint" in markets is essential for preserving price discovery functions. Second, to control financial risks. Holding large-scale assets implies greater exposure to mark-to-market losses and increases volatility in remittances to the Treasury. Recent unrealized losses from holding long-duration securities have become an unavoidable issue. Third, to safeguard the monetary-fiscal boundary. A large balance sheet objectively involves the Fed in credit allocation, blurring the lines between monetary and fiscal policy. Furthermore, paying substantial interest on reserves is viewed by some lawmakers as an implicit subsidy to financial institutions. Fourth, to preserve policy ammunition. If another zero lower bound crisis occurs, the Fed would need to expand its balance sheet to provide easing space. Compressing the balance sheet to a reasonable size now preserves necessary flexibility for future policy actions. Milan acknowledged that many consider significant balance sheet reduction "impossible," but he holds a截然不同 view: "Balance sheet reduction is a solvable challenge; those who outright dismiss it simply lack imagination."
**Key Diagnosis: The Constraint is 'Demand,' Not 'Supply'**
Understanding this debate requires clarifying a long-misinterpreted logical structure. The traditional framework suggests the constraint on Fed balance sheet reduction comes from "reserve supply hitting the steep part of the demand curve"—once supply tightens to a critical point, overnight rates become volatile. Thus, the Fed could only stop reduction passively after reserves became "scarce." The September 2019 repo market stress was a real-world example. The paper's breakthrough is shifting the perspective from "supply" to "demand." It argues that reserve demand is not an exogenous constraint determined "naturally" by payment activities but is artificially elevated by regulatory rules, supervisory practices, and the Fed's own operational framework—a phenomenon Milan terms "regulatory dominance" over the Fed's balance sheet.
Specifically, three mechanisms collectively raise the baseline demand for reserves:
1. **Interest Spreads Make Reserves a "Easy-Earn" Asset:** Since the Fed began paying interest on reserves (IORB) in 2008, reserves transformed from a pure settlement necessity into an asset competing with Treasury bills. Historical periods where IORB exceeded 1-month/3-month T-bill yields made banks prefer hoarding reserves from a risk-return perspective. 2. **Multiple Liquidity Regulations Create a "Ratchet Effect":** Rules like the Liquidity Coverage Ratio (LCR), Internal Liquidity Stress Testing (ILST), Resolution Liquidity Execution Need (RLEN), Net Stable Funding Ratio (NSFR), and Supplementary Leverage Ratio (SLR) intertwine, creating a dilemma—relaxing one rule often causes another to immediately become the new binding constraint. 3. **Long-Standing "Stigma" of the Discount Window:** Factors like a relatively high discount window rate, historical association with "troubled banks," and risks of disclosure and regulatory scrutiny lead banks to hoard reserves heavily rather than use policy tools during liquidity stress. Similar stigma has spread to the Standing Repo Facility (SRF).
This diagnosis implies a fundamental policy path: instead of waiting for reserves to become scarce again, the Fed could lower the "scarce-ample" demarcation line, allowing the ample reserves framework to function normally with a smaller balance sheet.
**How Much Can Be Reduced: Quantitative Estimates of $1.2T to $2.1T**
Based on Fed H.4.1 data from March 11, 2026, when total Fed assets were approximately $6.646 trillion, the liability structure was: reserves ~$3.073T, currency in circulation $2.390T, Treasury General Account (TGA) ~$806B, and foreign reverse repo pool ~$325B. The paper provides quantitative estimates for 15 policy options across two main directions but crucially avoids simple summation. Due to correlations and substitutability between options, it uses a Monte Carlo aggregation method under the OMB A-4 framework, yielding the following confidence intervals:
| Dimension | 95% Confidence Interval | Median | | :--- | :--- | :--- | | Potential Reduction in Reserve Demand | $825B - $1.75T | ~$1.287T | | Potential Total Balance Sheet Reduction | $1.15T - $2.125T | ~$1.637T |
Milan compared these ranges to historical benchmarks: * **15% of GDP:** The balance sheet level after the first QE program ended in 2009, when the banking system functioned normally. * **18% of GDP (2012 or 2019 levels):** Reflects the banking system's true liquidity needs after Basel reforms and Dodd-Frank Act requirements became clear.
The current Fed balance sheet is about 21% of GDP. Based on the paper's median estimate, successful reforms could bring it back close to 2012 or 2019 relative levels. As for returning to the pre-crisis level below 10% of GDP, Milan stated clearly: "Unrealistic and unnecessary."
**How to Reduce: A 'Menu' Analysis of 15 Options**
The paper categorizes 15 policy tools into two main types, providing effect range estimates and implementation prerequisites for each.
**Type 1: Lowering Equilibrium Reserve Demand**
**(A) Regulatory Reforms** * **LCR Reform:** A core measure allowing banks to count financing capacity from loans pre-pledged at the discount window (non-HQLA) towards HQLA, subject to a cap. Estimated impact: $50B-$450B reduction in reserve demand. The paper cautions that reforming only LCR might make NSFR the new binding constraint, requiring holistic consideration. * **ILST & RLEN Reforms:** If supervisors recognize discount window capacity and short-term liquidity sources, ILST reform could reduce reserve demand by $50B-$200B; RLEN reform, by extending the assumed availability window for the discount window, is estimated at $0-$100B.
**(B) Supervisory Practice Adjustments** If banks hold excess reserves to meet examiner preferences (i.e., T-bills and reserves are not treated equally), adjusting supervisory practices could yield a $25B-$50B reduction. This requires a cultural shift, not legal changes, but is equally challenging.
**(C) Reducing the Attractiveness of Holding Reserves** Allowing the Effective Federal Funds Rate (EFFR) to exceed IORB, breaking the current pattern. Citing the Lopez-Salido & Vissing-Jorgensen (2025) framework, an "EFFR-IORB = +2bp" scenario (near Sept 2019 stress levels) could reduce reserve demand by $150B-$550B. However, this path increases volatility in overnight and repo rates and might be partially offset if it prompts higher precautionary hoarding. It requires supporting mechanisms like SRF and temporary open market operations (TOMO).
**(D) Enhancing Attractiveness of Alternative Assets** Includes upgrading Fedwire, improving Treasury market liquidity, and advancing central clearing. The goal is to make assets like Treasuries nearly as attractive as reserves to banks, also aiding private sector absorption of securities released during balance sheet reduction.
**(E) De-stigmatizing Fed Liquidity Facilities** Reducing banks' precautionary reserve demand by eliminating stigma associated with the discount window, SRF, and daylight overdrafts. This requires systematic efforts from the Fed on transparency, pricing, and supervisory communication.
**Type 2: Directly Reducing Non-Reserve Liabilities**
**(A) Recalibrating TGA Management** Reducing the Treasury's cash buffer at the Fed from "~5 days of operational funds" to "~2 days," with excess funds moved back to commercial banks (similar to historical TT&L arrangements). Estimated balance sheet reduction: $200B-$400B. The paper notes that deposits returning to banks increase their reserve demand, so the net effect isn't one-to-one.
**(B) Reducing Attractiveness of Foreign Reverse Repo Pool** Guiding foreign central banks and sovereign funds to move funds from the Fed's reverse repo pool to the Treasury market via lower rates or size caps. Estimated impact: $0-$100B, relatively limited and dependent on external cooperation.
**Warsh's Signal: From Technical Paper to Policy Expectations**
Understanding this paper requires considering Fed personnel changes. Markets widely expect Warsh to become Fed Chair. Warsh has long criticized post-QE balance sheet expansion and frequently expressed a preference for reduction. This working paper, led by Milan, is seen as a前瞻 signal of potential policy direction under a "Warsh Fed." CITIC Securities notes that given Warsh's stance and the potential space revealed by the paper, a gradual exploration of restarting balance sheet reduction is possible under his leadership. However, both the paper and speech emphasize that pace and sequencing are critical constraints. Milan stated clearly: "Once preparatory work for reforms begins, following the typical government pace under the Administrative Procedure Act (APA), it could easily take over a year, even several years." He cited SLR reform, which took nearly six years from temporary relief to final rule. This implies the Fed won't immediately restart balance sheet reduction based solely on this paper. A more likely path involves starting research on less controversial, technically feasible options while providing forward guidance on new mechanisms.
**CITIC's Analysis: Feasible vs. Idealistic Options**
CITIC Securities Research Team systematically assessed the 15 policy options for practical feasibility, concluding:
**Options with Realistic Feasibility:** * Easing LCR standards: A technical regulatory reform with relatively controllable variables, giving the Fed significant initiative. * Reforming the Standing Repo Facility (SRF): De-stigmatization is relatively straightforward, not requiring external legislation. * Upgrading payment systems like Fedwire: Long-term infrastructure improvements with a clear direction. * Adjusting ILST supervisory practices: Some reforms can proceed without legal changes, via cultural shifts.
**More Ambitious or Externally Dependent Options:** * Tiered reserve remuneration: Could trigger non-linear reactions in the banking system and is operationally complex. * TGA management reform: Requires coordination between the Treasury and the Fed, needing political consensus. * Reducing the foreign reverse repo pool: Highly dependent on external cooperation, with uncertain effects.
Overall, CITIC views this as "a practical and reference-worthy reform menu," but actual implementation will be much slower than the paper's potential upper limits. It should be seen as directional guidance rather than a near-term policy commitment.
**Market Impact: Increased Volatility, But Unchanged Rate Cut Logic**
For bond markets, balance sheet reduction essentially reduces base money supply, increasing the volume of Treasuries the private sector must absorb. CITIC believes this will amplify market volatility and raise tail risks—although some deregulatory measures (like SLR relief) could help expand dealer capacity. Regarding pace, the paper explicitly opposes accelerating reduction via direct asset sales, favoring instead allowing securities to roll off naturally upon maturity while enhancing dealer and repo market absorption capacity. This objectively limits short-term shock intensity. CITIC judges that US Treasuries are currently more suitable for tactical opportunities, with short-term bonds potentially outperforming long-term bonds. For stock markets, balance sheet reduction exerts a contractionary effect via money supply and portfolio balance channels, but this can be counteracted by lowering the federal funds rate. CITIC believes that if reduction reforms proceed, the need to adjust the interest rate path increases, but this has limited direct link to current policy rhythm. US stocks might wait for pullbacks to find better safety margins. For gold markets, balance sheet reduction reforms are unlikely to fundamentally alter the strategic logic behind global central bank gold accumulation, which is driven more by geopolitical shifts and dollar diversification trends. Gold retains medium-to-long-term allocation value. Milan explicitly stated that contractionary effects from balance sheet reduction can be counteracted by rate cuts, and "reduction might allow for a larger federal funds rate cut compared to the baseline scenario." CITIC expects US CPI to fluctuate between 3.0%-3.5% YoY this year and maintains its forecast for a 25bps Fed rate cut in H2, noting no direct link between reduction reforms and rate cut decisions.
Comments