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

According to Morgan Stanley’s latest report, the bank believes the Federal Reserve could reduce its balance sheet by about $1.5 trillion over the next few years. In the report, Carpenter emphasizes that this seemingly huge number may have a much lower actual impact on the market than expected—the key is that the Federal Reserve has multiple operational tools, allowing it to shrink the balance sheet under the “ample reserves” framework and maintain market liquidity, without significantly pushing up market interest rates or tightening financial conditions.

This view directly challenges the market’s conventional logic. Carpenter points out that the market habitually links the size of the balance sheet mechanically with asset prices, but ignores the underlying accounting mechanisms and operational details. He warns that the upcoming policy discussions are “more about accounting than about markets.” This means the traditional analysis frameworks that equate balance sheet reduction with tightening, and thus automatically bearish views on risk assets, may need to be reconsidered.

In the report, Carpenter outlines several paths the Fed can take to reduce its balance sheet, most of which have limited direct market impact.

The Treasury General Account is the most direct entry point. Currently, the Treasury holds about $800 billion to $1 trillion in cash at the Fed. Reducing this by up to $500 billion could directly compress the Fed’s balance sheet, with no impact on the market.

Foreign official reverse repo holdings are another potential source for compression. In recent years, foreign official holdings in the Fed’s reverse repo pool have grown to about $350 billion, and the Fed could adjust related terms to reduce this amount.

The tiered Interest on Reserve Balances (IORB) mechanism could be the most profound tool. Carpenter believes the Fed could continue to pay banks market-level interest rates on a portion of reserves, but significantly reduce the rate paid on excess holdings—setting it markedly lower than short-term Treasury yields. This would incentivize banks to move excess reserves into Treasury bills, thus shrinking the required level of reserves to about half its current size while maintaining the “ample reserves” regime.

Additionally, adjustments to regulatory rules such as the Liquidity Coverage Ratio (LCR) could lower banks’ reserve needs and create further space for balance sheet reduction.

During the balance sheet reduction process, the Fed will be releasing its holdings of Treasuries, which the Treasury will need to refinance in the market. Carpenter says this is the asymmetric core of the issue.

When banks, due to IORB adjustments, turn to holding more short-term Treasury bills, it is natural for the Treasury to expand issuance of short-term Treasuries to meet new demand—this is closely aligned with the Treasury’s usual preference for short-end financing. Carpenter estimates that issuing an additional $1 trillion in short-term Treasuries would not push their proportion beyond historical normal ranges.

The final result: the Fed’s balance sheet shrinks, but the market’s overall duration risk may not rise significantly. This stands in marked contrast with the usual market concern that balance sheet reduction will put upward pressure on long-term interest rates.

The report notes that current Fed Chair Warsh has long preferred to reduce the Fed’s presence in the market, and this stance is well established. Although in his public remarks in June Warsh gave no clear guidance on rates or the balance sheet path, Morgan Stanley still judges there is a significant probability of substantive balance sheet reduction.

Carpenter also flagged key risks. If the Fed were to actively sell MBS (Mortgage-Backed Securities), and the scale is large, market impact will be significant. In addition, the ultimate path of the balance sheet depends largely on the Treasury’s debt issuance decisions, which means the balance sheet itself is not the only variable.

Carpenter emphasizes that the stance of monetary policy and the size of the balance sheet are two independent dimensions and should not be conflated by investors. Simply using the size of the balance sheet as a proxy for the stance of policy fundamentally ignores the operational complexity involved.