ECONOMICS : Fed: The balance sheet under Warsh; rethinking the Fed’s footprint under a new Chair

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ECONOMICS : Fed: The balance sheet under Warsh; rethinking the Fed’s footprint under a new Chair

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Executive Summary

We see the balance sheet shrinking gradually

Economics

Warsh to pursue smaller balance sheet: We think shrinking the central bank’s balance sheet will be

among Fed Chair Warsh’s top priorities. To achieve this will require the Fed to first reform supervisory

and regulatory (S&R) requirements, in our view. This will take time, with 2028 being the fastest realistic

outlook. We expect balance sheet adjustments to take place gradually and predictably, with changes

in related flows announced infrequently, well in advance, and following a reasonably transparent

framework.

Gradual and predictable: In our base case, reserve demand could drop as much as ~$700bn

following reforms, with the balance sheet decreasing afterward. We note, however, high uncertainty

around these forecasts and will update the base case as we receive new information.

In practice, we think the Fed will monitor the spread between the Tri-Party General Collateral Rate

(TGCR) and the Interest on Reserve Balances Rate (IORB) and adjust balance sheet growth based

on this: faster if TGCR softens (because of weaker reserve demand) and slower if it firms up. This

empirically driven approach would emphasize to the market that market stability is the Fed’s most

important policy objective.

Aware of tantrum risks: Ample historical experience shows that markets can have outsized,

macroeconomically relevant reactions to changes in balance sheet policy – especially the

communication around such moves – even before they happen. This occurred in 2013, 2018 and 2019.

Early signs that these outcomes can be avoided on this occasion seem positive. Treasury Secretary