The Federal Reserve is inclined to reduce the size of its bond holdings, but any such move will require extensive public preparation and will take a considerable amount of time to implement, according to recent comments from a key official.
Federal Reserve Chair Kevin Warsh reiterated his preference for the central bank to shrink its balance sheet on Wednesday, while stressing that any such action would only follow sufficient public groundwork. "It took us about 18 years to build a balance sheet of this size—in my view, it's pushing the boundaries of fiscal policy," Warsh stated at the European Central Bank's annual forum in Sintra, Portugal.
"It will take us more than 18 weeks to shrink it to an appropriate size."
Warsh, who last month proposed forming a special working group to examine balance sheet issues, indicated on Wednesday that the group would include "external participants." While he remains "open-minded," he expressed his desire for interest rate policy to remain the Fed's primary tool. He emphasized that any decisions would be made collectively by the full Federal Open Market Committee and the Board of Governors.
Easier to Expand Than to Contract: Wall Street Forecasts No Fed Balance Sheet Reduction Before 2027
Warsh's remarks have reinforced Wall Street's prevailing view that any significant reduction of the Fed's balance sheet is unlikely to materialize before 2027. The central bank's asset portfolio ballooned rapidly through multiple rounds of asset purchase programs during the global financial crisis and the COVID-19 pandemic.
Fed assets peaked at nearly $9 trillion in June 2022, a stark increase from less than $900 billion in 2007. The current size of the Fed's balance sheet stands at $6.7 trillion.
Michael Cloherty, a strategist at CIBC, has consistently argued that the process of further balance sheet reduction by the Fed will likely be slow and limited in scale. The bank anticipates the Fed will unveil a plan by year-end, followed by a public consultation period extending into the second quarter of 2027, with the actual balance sheet runoff commencing in the fourth quarter of next year.
Although Warsh has long advocated for a substantial reduction in the Fed's footprint in asset markets, Wall Street strategists widely doubt the central bank's ability to achieve a major balance sheet contraction. Many believe the U.S. financial system has become structurally reliant on a larger supply of reserves—the counterpart to the securities the Fed holds and a key source of high-quality liquidity for banks.
Any attempt to shrink the balance sheet too quickly could destabilize short-term funding markets.
"The alternative is to create scarcity. But the risks of creating that kind of scarcity far outweigh the benefits—it could ultimately blow up the repo market," said Samuel Earl, a strategist at Barclays.
Warsh noted on Wednesday that details regarding the composition of the various special working groups announced in June, including the one on the balance sheet, would be released soon, "likely next week." Other groups are focused on the Fed's data usage, productivity and employment, communication methods, and its inflation framework.
Last year, the Fed abruptly halted its balance sheet reduction process, known as quantitative tightening, and instead began replenishing reserves in the financial system by purchasing Treasury bills maturing within one year.
In December, the Fed started buying roughly $40 billion per month in U.S. Treasuries to alleviate pressure from rising short-term rates. Then-Chair Jerome Powell stated at the time that the move was to "get ahead" of purchases to ensure ample reserves ahead of the April tax season.
The Fed surprised market participants in April by cutting its so-called reserve management purchases to $25 billion, having previously indicated that reductions might be "gradual" due to uncertainty and other factors.
Last month, the Fed further reduced its purchase pace to $10 billion, another sharp cut that caught markets off guard. The purchase pace remained unchanged for the June-July cycle.
Cumulatively, the Fed's Treasury bill purchases since they began on December 12 will total approximately $310 billion.
Downplaying Inflation Risks and Upholding Policy Independence
Warsh also stated on Wednesday that inflation risks in the U.S. have eased as recent inflation expectations have moderated. However, he affirmed the Fed's unwavering commitment to bringing inflation down to its 2% target and emphasized the central bank's independence in monetary policy decisions, free from political influence.
Warsh reiterated that the Fed would no longer provide "forward guidance" on the future path of interest rates as it has in the past.
Last month, the Fed maintained the federal funds rate target range at 3.5% to 3.75%. However, officials hinted that the likelihood of a rate hike this year is increasing, given that inflation is currently at its highest level since 2023.
The latest "dot plot" projections show that nine out of eighteen policymakers anticipate at least one rate hike this year, though Warsh himself declined to offer a prediction. Investors currently expect the Fed to implement at least one 25-basis-point rate hike by year-end.
The Fed's next monetary policy meeting is scheduled for July 28-29.
Addressing the topic of artificial intelligence, Warsh said it is still too early to judge whether the current investment boom will trigger broad-based inflation. He believes the new technology will ultimately stimulate a supply-side boom, thereby boosting productivity. He noted that AI's economic impact will become clearer in the coming months.
"While we might see some business surveys saying 'it's no big deal,' I suspect the surveys six months from now will tell a very different story," he said. "We are in the first or second phase of this transformation. It's a massive paradigm shift."
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