MS Fed Balance Sheet Reform More Shrinkage, Less Tightening

Global Economics and Fixed Income Strategy Morgan Stanley & Co. LLC Foundation

Seth B Carpenter | North America Chief Global Economist

Fed Balance Sheet Reform: Michael T Gapen Chief US Economist

More Shrinkage, Less Tightening Matthew Hornbach Strategist

Martin W Tobias, CFA Chairman Warsh has put balance-sheet reform on the agenda. Strategist We expect the Federal Reserve to shrink its balance sheet by Jay Bacow Strategist roughly $1.5tr over two years while retaining an ample-reserves

regime; bill-heavy funding should limit market effects, while Arunima Sinha Global Economist mortgage sales and scarce reserves carry larger risks.

Eli P Carter Strategist Key Takeaways

Our base case calls for roughly $1.5tr of balance-sheet reduction, beginning as Janie Xue Strategist early as 1Q27 and taking roughly two years, within a plausible $0.6-2.5tr range.

We think the Federal Reserve keeps its ample-reserves regime as tiered interest on reserves lowers demand, letting reserve supply and the balance sheet fall.

The headline decline should overstate the market impact. A smaller Treasury cash balance and bill-funded runoff add little duration risk for private investors.

Passive Treasury runoff could reach $1tr per year, limiting the need for sales. Agency mortgage sales could widen lower-coupon spreads by 10-20 basis points.

Beyond mortgage sales (low probability), risks skew to coupon-heavy Treasury funding or scarce reserves; monitor repo volatility, and funding spreads.

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Executive Summary Chair Warsh has put Federal Reserve (Fed) balance-sheet reform on the policy agenda and announced a task force at the June Federal Open Market Committee (FOMC) meeting. We expect the Fed to begin reducing its balance sheet as early as 1Q27, with roughly $1.5tr of reduction over about two years and a plausible range of approximately $0.6tr to $2.5tr.

The effect on financial conditions will depend on which Fed liabilities decline, which assets leave the System Open Market Account (SOMA), how Treasury finances maturing holdings, and whether reserves remain ample. Under our base case, a smaller Treasury cash balance, lower reserve demand, and bill-funded Treasury runoff would return little duration to private investors.

Warsh has argued that quantitative easing (QE) may have served a purpose during periods of acute stress but persisted too long, distorted market pricing, and blurred the line between monetary and fiscal policy. Secretary Bessent’s view that Treasury should determine the maturity of the consolidated government’s liabilities points in the same direction, while we take the narrower view that the balance sheet remains an instrument for implementing monetary policy.

We expect the Fed to retain ample reserves

Before the Global Financial Crisis, the Fed sometimes operated with roughly $20bn of reserves under a scarce-reserves framework. The current ample-reserves framework supplies more reserves than banks demand and uses administered rates to anchor overnight money-market rates.

We expect the Fed to preserve that framework while reducing both reserve demand and reserve supply. Recent Federal Reserve staff research estimates that a combination of reforms could allow roughly $1.2tr to $2.1tr of balance-sheet reduction within an ample- reserves framework.

A return to scarce reserves will likely enter the policy discussion, but it would require more implementation work and expose money markets to greater day-to-day funding volatility. Further balance-sheet reduction could prove possible under that framework, although the Fed would need to proceed slowly enough for markets to absorb the securities leaving SOMA.

Lower reserve demand should allow reserves…