Morgan Stanley economists Seth Carpenter and Michael Gapen released a report stating that their base case forecast is for the Federal Reserve to reduce its balance sheet by approximately $1.5 trillion over roughly two years, with the process potentially beginning as early as the first quarter of 2027; a reasonable range for the reduction is between $600 billion and $2.5 trillion.
The economists anticipate that the Fed will continue to maintain an ample reserves framework while lowering both reserve demand and supply. Policy discussions may begin to pivot toward a return to a scarce reserves framework, but this would require more preparation for implementation and could also expose money markets to greater daily funding volatility.
Introducing tiered interest rates on reserve balances would encourage banks to replace some reserves with U.S. Treasury bills. Treasury bills are treated similarly to reserves under regulatory standards while still earning returns at market rates.
Additionally, the economists estimate that other Fed liability items could provide hundreds of billions of dollars in additional space for balance sheet reduction, such as the U.S. Treasury General Account (TGA) and cash from foreign official institutions held in the reverse repo facility.
"Reducing the balance sheet can be a technical operation," they wrote. "If executed cautiously, the impact of balance sheet normalization on financial markets and financial conditions could be minimal, as it can avoid reintroducing significant duration risk to the private sector and exert no noticeable marginal effects on financial conditions."
Risks associated with balance sheet normalization are more likely to arise during the transition phase rather than from the decline in asset holdings themselves. Examples include inadvertently causing reserves to shrink too quickly, failing to adjust liquidity regulations accordingly, failing to reduce the stigma associated with using the discount window, or disrupting money market operations.
Strategists Matthew Hornbach, Martin Tobias, and Jay Bacow noted that the impact of balance sheet reform on the market should depend less on the total scale of the reduction and more on specific choices: which liabilities decline, which assets exit the Fed's System Open Market Account (SOMA), how the U.S. Treasury will finance this adjustment, and whether reserves remain ample.
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