"Balance Sheet Reduction ≠ Tightening"! Morgan Stanley Explains the Fed's "Asymmetric Balance Sheet Reduction"

Is balance sheet reduction equivalent to tightening? Morgan Stanley believes the market fundamentally misunderstands the relationship.

Written by: Xu Chao

Seth Carpenter, Chief Economist at Morgan Stanley, points out that the Federal Reserve's reduction of its balance sheet does not equate to tightening monetary policy, and the market has long held a fundamental misunderstanding of the relationship between the two.

According to Morgan Stanley's latest report, the bank believes the Fed could reduce its balance sheet by about $1.5 trillion over the next few years. Carpenter emphasizes in the report that this seemingly large number may have far less actual impact on the market than expected—key to this is that the Fed has multiple operational tools at its disposal to complete the balance sheet reduction while maintaining a framework of "ample reserves" and ensuring market liquidity, without significantly raising market interest rates or tightening financial conditions.

This view directly challenges the market's conventional logic. Carpenter notes that the market tends to mechanically link the size of the balance sheet to asset price movements, overlooking the underlying accounting mechanisms and operational details. He warns that the upcoming policy discussions "are more about accounting than about the market." This suggests that the previous analytical framework equating balance sheet reduction with tightening, and thus automatically bearish on risk assets, may need to be re-evaluated.

Multiple Tools at Hand, Balance Sheet Reduction Need Not Affect the Market

Carpenter outlines several paths for the Fed's balance sheet reduction in the report, most of which have limited direct impact on the market.

The Treasury account is the most direct entry point. Currently, the Treasury has a cash balance of about $800 billion to $1 trillion held at the Fed. If this is reduced by up to $500 billion, it could directly compress the Fed's balance sheet without affecting the market.

The reverse repo holdings of foreign official institutions are another compressible source. In recent years, the holdings of foreign official institutions in the Fed's reverse repo pool have ballooned to about $350 billion, and the Fed could adjust the relevant terms to bring this down.

The Interest on Reserves Balance (IORB) tiering mechanism may be the tool with the most far-reaching impact. Carpenter believes the Fed can continue to pay interest on a portion of reserves held by banks at close to market levels, but significantly lower the interest paid on excess reserves—making it clearly below the short-term Treasury rates. This would encourage banks to shift excess reserves towards holding Treasury bills, thereby compressing the actual required reserve size to about half of the current level while maintaining the "ample reserves" system.

Additionally, adjustments to regulatory rules such as the Liquidity Coverage Ratio (LCR) may also reduce banks' demand for holding reserves, further creating space for balance sheet reduction.

The Structure of Treasury Supply is Key, Duration Risk May Not Rise

During the balance sheet reduction process, the Fed will release its held Treasuries, and the Treasury must refinance in the market. Carpenter believes this is the core of the "asymmetry."

When banks increase their holdings of short-term Treasury bills due to IORB adjustments, it is natural for the Treasury to expand the issuance of short-term Treasuries to meet the new demand—this aligns closely with the Treasury's consistent preference for short-term financing. Carpenter estimates that an additional issuance of about $1 trillion in short-term Treasuries would not push its share out of the historically normal range.

The end result is that while the Fed's balance sheet shrinks, the overall duration risk borne by the market may not significantly increase. This stands in stark contrast to the market's usual concern that "balance sheet reduction leads to increased upward pressure on long-term rates."

Expectations for Balance Sheet Reduction Heat Up Under Warsh's Leadership, but Risks Remain

The report notes that current Fed Chair Warsh has long favored compressing the Fed's market presence, a position that has been well established. Although Warsh did not provide clear guidance on the path of interest rates and the balance sheet in his public statements in June, Morgan Stanley still assesses that there is a significant possibility of substantial balance sheet reduction.

Carpenter also points out major risk factors. If the Fed initiates active sales of MBS (mortgage-backed securities) on a large scale, the market impact will be non-negligible. Furthermore, the ultimate trajectory of the balance sheet largely depends on the Treasury's debt issuance decisions, meaning that the Fed's balance sheet itself is not the only variable.

Carpenter emphasizes that monetary policy stance and balance sheet size are two independent dimensions that investors should not conflate. Simply using the size of the balance sheet as a proxy for the tightness of policy fundamentally overlooks the complexities at the operational level.

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