Morgan Stanley Chief Economist Seth Carpenter argues that the Federal Reserve's balance sheet reduction is not equivalent to monetary policy tightening, suggesting a fundamental misreading of the relationship by markets.
According to the latest report, Morgan Stanley believes the Fed could reduce its balance sheet by approximately $1.5 trillion over the coming years. Carpenter emphasizes that the actual market impact of this seemingly large figure may be far lower than expected. The key lies in the Fed's multiple operational tools, allowing it to shrink the balance sheet under the "ample reserves" framework while maintaining market liquidity, without significantly raising market rates or tightening financial conditions.
This view directly challenges common market logic. Carpenter notes that markets tend to mechanically link balance sheet size to asset price trends, overlooking the underlying accounting mechanisms and operational details. He warns that the upcoming policy debate "is more about accounting than about markets." This suggests that the traditional analytical framework, which equates balance sheet reduction with tightening and automatically turns bearish on risk assets, may need to be reconsidered.
Multiple Tools Available, Balance Sheet Reduction Need Not Disrupt Markets
Carpenter outlines several pathways for the Fed to reduce its balance sheet, most of which have limited direct impact on markets.
The Treasury General Account (TGA) is the most direct entry point. The Treasury currently holds cash balances of roughly $800 billion to $1 trillion at the Fed. Reducing this by up to $500 billion would directly compress the Fed's balance sheet with zero market effect.
Foreign official institutions' reverse repo holdings are another compressible source. In recent years, foreign official holdings in the Fed's reverse repo facility have swelled to about $350 billion. The Fed could adjust related terms to bring them down.
The Interest on Reserve Balances (IORB) tiering mechanism could be the most impactful tool. Carpenter suggests the Fed could continue paying near-market rates on a portion of bank reserves but sharply cut the rate on excess holdings, making it significantly lower than short-term Treasury yields. This would incentivize banks to shift excess reserves into Treasury bills, effectively halving the actual required reserve size while maintaining the "ample reserves" regime.
Additionally, adjustments to regulatory rules like the Liquidity Coverage Ratio (LCR) could reduce banks' demand for reserves, further creating space for balance sheet reduction.
Treasury Supply Structure is Key, Duration Risk May Not Rise
During balance sheet reduction, the Fed will release held Treasury securities, and the Treasury must refinance them in the market. Carpenter sees this as the core of "asymmetry."
When banks pivot to increase holdings of short-term Treasury bills due to IORB adjustments, it is natural for the Treasury to expand short-term bill issuance to meet new demand. This aligns well with the Treasury's longstanding preference for shorter-duration funding. Carpenter estimates that an additional $1 trillion in short-term Treasury issuance would not push its share outside historical normal ranges.
The end result: the Fed's balance sheet shrinks, but the overall duration risk borne by the market does not necessarily rise significantly. This contrasts sharply with the market's usual concern that "balance sheet reduction increases upward pressure on long-term yields."
Warsh's Leadership Raises Reduction Expectations, But Risks Remain
The report notes that current Fed Chair Warsh has long favored reducing the Fed's market presence, a stance that is well-established. Although Warsh did not provide clear guidance on the rate path or balance sheet direction in his June public remarks, Morgan Stanley still judges that substantial balance sheet reduction is likely.
Carpenter also highlights key risk factors. If the Fed initiates active sales of Mortgage-Backed Securities (MBS) on a large scale, the market impact would be significant. Furthermore, the ultimate direction of the balance sheet largely depends on the Treasury's debt issuance decisions, meaning the Fed's balance sheet alone is not the sole variable.
Carpenter emphasizes that the monetary policy stance and the size of the balance sheet are two independent dimensions that investors should not conflate. Simply using balance sheet size as a proxy for policy tightness fundamentally ignores the complexity of operations.
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