Federal Reserve’s Plans for Balance Sheet Reduction

NEW YORK (Reuters) – Federal Reserve Governor Christopher Waller indicated on Thursday that the U.S. central bank still has significant work ahead in reducing its holdings. He suggested a possible endpoint for the ongoing reduction while reaffirming the case for a potential interest rate cut later this month.

Waller stated that, considering the necessary level of bank reserves, the Fed can allow its bonds to mature without replacing them, thus decreasing reserve balances. His remarks were made during an event organized by the Dallas Fed.

With the Fed’s balance sheet currently at $6.7 trillion, including $3.3 trillion in bank reserves, Waller theorized that a target balance sheet size could be around $5.8 trillion, with reserves at $2.7 trillion and $780 billion in the Treasury Department’s account with the Fed. He referred to money market volatility in late 2019, emphasizing that reserves falling below 8% of GDP is concerning and helped inform his estimates for overall Fed holdings.

After a substantial increase of its balance sheet to a peak of $9 trillion due to pandemic-related bond purchases, the Fed has been gradually selling Treasury and mortgage bonds over the past three years as part of its monetary policy normalization efforts. They are currently trying to reduce excess liquidity via a process known as quantitative tightening (QT), although the duration of this effort remains uncertain. Waller has previously expressed skepticism regarding the balance sheet’s use as a stimulus tool due to the unclear impacts on the economy.

Shift in Fed Holdings

Waller spoke following the release of minutes from the Fed’s June 17-18 policy meeting, which indicated that most officials were hesitant about rate cuts, anticipating potential long-term inflation due to President Donald Trump’s tariffs. However, Waller and Fed Vice Chair for Supervision, Michelle Bowman, have shown openness to rate cuts at the upcoming July meeting, viewing any related inflation surge from tariffs as likely a transient event.

Regarding interest rates, Waller maintained his stance, suggesting that monetary policy is currently too tight and the central bank might need to consider reducing the policy rate in July. Despite being in the minority, he emphasized the economic rationale behind this perspective, separating it from political considerations.

Waller is a candidate to possibly succeed Fed Chairman Jerome Powell, and with President Trump advocating for aggressive rate cuts, his dovish stance has sparked considerable debate among economists and observers.

The Fed minutes also revealed that major banks and investment managers had slightly adjusted their expectations for the end of the balance sheet reduction to the following February, anticipating a decrease to $6.2 trillion and $2.9 trillion in reserves.

In his speech, Waller highlighted the Fed’s current concentration on long-term bonds due to prior stimulus measures and suggested that a gradual reevaluation of Fed holdings toward Treasury bills may be beneficial. However, he noted that this transition could be slow unless the Fed undertakes significant measures to sell existing securities in favor of Treasury bills. He suggested they may ultimately need to adjust their holdings to shorter-term securities based on evolving economic conditions in the future.