How will the Federal Reserve (or) reduce its balance sheet?

Author: Stephen Miran, Federal Reserve Governor

Speech by Federal Reserve Governor Stephen Miran, based on his paper with Federal Reserve staff, A User’s Guide to Reducing the Federal Reserve’s Balance Sheet.

Thank you, Francisco, for the warm introduction. It’s an honor to be here at the Miami Economic Club. Tonight, I will discuss a topic too big to ignore: the Federal Reserve’s balance sheet. Like any other bank, the Federal Reserve’s balance sheet records the assets and liabilities we hold. The assets primarily include U.S. Treasury securities and agency mortgage-backed securities (MBS). The liabilities consist of all currency in circulation, the reserve balances of banks at the Federal Reserve, and the Treasury’s general account deposits. The size and composition of these holdings are crucial because they affect the money supply in the banking system and have broader implications for financial conditions. Understanding how the balance sheet operates is essential for grasping how the Federal Reserve maintains economic stability and implements monetary policy.

Tonight, I will explore the various mechanisms the Federal Reserve has experienced in operating its balance sheet and explain why, in my view, reducing the size of the balance sheet is desirable. Next, I will outline why reducing the balance sheet is a challenge that can be addressed, followed by a discussion of potential paths to achieve this goal. Finally, I will summarize the implications of this move for monetary policy.

Reasons for Balance Sheet Reduction

Modern balance sheet policy revolves around three somewhat vague concepts: “scarce,” “ample,” and “abundant” reserves. Before the 2008 global financial crisis, the Federal Reserve operated under a scarce-reserve regime. Under this regime, the Federal Reserve maintained relatively tight reserves and frequently intervened directly in the markets, using open market operations to steer the federal funds rate toward its target level. After the crisis, the Federal Reserve shifted to an ample-reserve regime, where banks hold enough reserves so that the Federal Reserve does not need to engage in active daily operations to control the policy rate. This system allows the Federal Reserve to control short-term rates primarily by setting the interest rates at which it participates in the market (i.e., managing rates). For an extended period after the crisis, reserves were also described as being in an “abundant” state, far exceeding the levels needed for smooth market operation. This was because quantitative easing (QE) policies greatly expanded the reserve balances.

Reducing the balance sheet is a goal worth pursuing for several reasons. We should strive to leave as small a footprint as possible in the market to minimize distortions caused by the government, including disintermediation in the funding markets. A smaller balance sheet also helps reduce the likelihood of the central bank incurring losses at market value and decreases the volatility of remittances to the Treasury. Additionally, a smaller balance sheet better maintains the boundary between monetary and fiscal policy: it preserves the duration characteristics of public debt as fiscal policy items, keeping the Federal Reserve out of cross-sector credit allocation games, and reduces interest payments on reserve balances (which some in Congress view as a subsidy to the banking system). Finally, a smaller balance sheet can reserve “dry powder” for policymakers to face scenarios of the zero lower bound on interest rates again.

However, despite these benefits of a smaller balance sheet, many people still believe it is simply not feasible. It’s a pipe dream—it will never happen. If you tell me that something is impossible, I can’t help but ask, “Really?” This trait has gotten me into some trouble, but I just can’t help myself. So, let’s think carefully about the possibilities here.

A Manageable Challenge

My overall assessment is that reducing the balance sheet is a manageable challenge. Those who outright reject the idea simply lack imagination. In addressing this challenge, I see three main issues.

The first issue is, how much can we reduce the balance sheet?** I believe we can reduce it significantly, but that doesn’t necessarily mean restoring it to the ratio of GDP it had before the financial crisis. I think getting back to that level is not feasible.** The demand for money has increased due to the growth of money demand, the regulatory framework established by the Dodd-Frank Act in the post-crisis period, and changes in market structure and expectations resulting from these, all of which have led to increased demand for reserves in the system.

The second issue is whether reducing the balance sheet from its current level necessarily requires a return to a scarce-reserve state.** I don’t think it has to. On the contrary, the Federal Reserve can take steps to lower the dividing line between scarce, ample, and abundant states.** Lowering these boundaries can be achieved through various policies that I will mention shortly. Moving these lines downward would allow the Federal Reserve to maintain an ample reserve policy while still reducing the size of the balance sheet.

The third issue is whether a return to a scarce-reserve mechanism is advisable or feasible. I believe that within the current regulatory and institutional framework, we can return to a scarce-reserve state, but it would involve trade-offs. These costs include accepting greater volatility in short-term interest rates; a higher tolerance for the Federal Reserve actively managing reserves; and more frequent and normalized use of liquidity tools provided by the Federal Reserve, such as intraday overdrafts, the discount window, or standing repurchase agreements. Your views on the impact of these side effects will determine whether you think a return to scarce reserves is advisable.

The Path Forward

Is lowering the boundary between scarce and ample easier said than done? Perhaps, but I see a path forward to achieve this goal. In the working paper I co-authored with several Federal Reserve colleagues, A User’s Guide to Reducing the Federal Reserve’s Balance Sheet, we outline measures that can effectively move these boundaries downward. These actions include the following steps:

• Relaxing the liquidity coverage ratio (LCR) (and related) requirements;

• Limiting expectations for internal liquidity stress tests and related disposal plan liquidity standards;

• Eliminating the stigma associated with the use of standing repurchase agreements, the discount window, and intraday overdrafts;

• Conducting more aggressive open market operations, especially around quarter-end and dates of significant fiscal importance;

• Making it easier for dealers to absorb securities;

• Making alternatives to reserves, such as Treasury securities, more liquid and attractive;

• Implementing policies within specific target ranges, with the effective federal funds rate slightly above the rate on reserves.

This is just one example of the steps we can take to reduce the size of the Federal Reserve’s balance sheet. There is more in the paper, and I encourage everyone to read it. It should be clarified that neither in the User’s Guide nor in today’s speech do I advocate any specific steps. I simply list the options we can identify so that when the time is right, the Federal Reserve can take concrete actions in that direction. Each option requires individual cost-benefit analysis.

Even if Federal Reserve decision-makers choose to return to a scarce-reserve state, taking measures to reduce reserve demand will make this process easier and allow for further balance sheet reduction while minimizing negative impacts. Some options (such as eliminating the stigma associated with repurchase agreements, the discount window, and intraday overdraft credit, or conducting temporary open market operations) will also improve market conditions under a scarce-reserve mechanism. I personally lean towards reducing demand while retaining ample reserves, but this is not an unshakeable belief.

Let’s return to my first question—how much can the balance sheet be reduced? As I said, the pre-crisis levels are not a realistic benchmark, so I offer two alternative scenarios:

1. Post-first round of QE: The balance sheet was about 15% of GDP. This level of the balance sheet may have been necessary to meet the liquidity needs of the financial sector. Subsequent rounds of quantitative easing and subsequent asset purchases began to expand the balance sheet, aimed at achieving our dual mandate goals, rather than for financial stability.

2. 2012 and 2019: Before embarking on open-ended QE and prior to the pandemic in 2019, the balance sheet was about 18% of GDP. Theoretically, this level reflects the liquidity needs of the banking sector when the requirements of the Dodd-Frank Act and Basel Accord became clear. It encompasses some of the so-called “ratchet effects” on the balance sheet but does not include the effects generated since the pandemic.

Broadly speaking, this range may reflect a balance sheet reduction of $1 trillion to $2 trillion, numbers that are reasonably discussed in the User’s Guide and do not require a return to a scarce-reserve state. Of course, the optimal size of the balance sheet is a topic worthy of deeper study, and perhaps measuring the size of the balance sheet through financial variables such as bank deposits rather than GDP would be better. I do not intend to resolve this issue today.

The tools listed in today’s User’s Guide will create significant room to further reduce the balance sheet, which I welcome. However, as the Federal Reserve strips securities from its balance sheet, policymakers need to ensure that financial markets can absorb these securities with minimal disruption.

The most important thing we can do is to take our time. It cannot be overemphasized how important this is. This also means allowing securities to mature naturally rather than selling them outright, as direct sales would realize losses on the balance sheet. If we see our securities trading at a profit, I can envision us selling them, but in other cases, we would not. Some of the other steps we mentioned in the User’s Guide may make it easier for the market to absorb the securities on our balance sheet.

Implications for Monetary Policy

Now that I have outlined some of the ideas we expanded upon in the User’s Guide, I would like to share a few thoughts at the end of my speech on how balance sheet operations affect the economy and monetary policy. I mainly believe this occurs through two channels:

First, through the supply of money and liquidity (the liabilities side of the Federal Reserve’s balance sheet), which is the channel in the classical monetarist sense. Reserves are high-powered money, and increasing their supply constitutes an expansion of the money supply. Second, through what economists refer to as the “portfolio rebalancing” effect (the assets side of the Federal Reserve’s balance sheet). To further explain this concept: Given a set of prices, the private sector’s capacity to absorb additional financial risk (including interest rate risk) is fixed. Therefore, the Federal Reserve removing or providing interest rate risk to the public will influence the private sector’s willingness to take on overall financial risk.

Ceteris paribus, reducing the balance sheet has a contractionary effect on the economy through these two channels. As long as we are not at the effective lower bound of interest rates, the contractionary effects of reducing the balance sheet can be offset by lowering the federal funds rate. Therefore, restoring the reduction of the balance sheet will likely require a more significant cut in the federal funds rate relative to baseline forecasts. However, quantifying these effects is a challenge, and I do not intend to attempt that at this time.

Conclusion

In conclusion, the benefits of reducing the Federal Reserve’s balance sheet are clear and achievable. The Federal Reserve’s balance sheet can be reduced, but policymakers should first take steps to ensure its success. I have outlined some of these possible steps today and provided more detail in the User’s Guide. Each of these steps may have pros and cons and must be thoroughly researched and calibrated.

Implementing these steps before beginning to reduce the balance sheet means there will be some time before we can truly start. Based on my experience with how the government navigates the Administrative Procedure Act, once a decision is made to proceed, this process may take over a year, and possibly several years. This timeline will determine when the Federal Open Market Committee (FOMC) decides to begin reducing the balance sheet and when it researches how to implement these changes, including providing forward guidance to the market on how the new mechanisms will operate. Moreover, once this process begins, I suggest slowing the pace of reductions to ensure the private sector can absorb all the securities we are shedding from our balance sheet. I am excited about all of this happening, but if or when it occurs, I expect progress to be slow.

Thank you once again to the Miami Economic Club for the opportunity to speak here tonight. I look forward to answering your questions.