With Kevin Warsh becoming a candidate for the chair of the Federal Reserve, the market's attention is once again focused on the central bank's balance sheet and communication strategy. Warsh has long criticized the Federal Reserve for 'overreaching'—not only is the balance sheet excessively large, obscuring the boundaries between monetary and fiscal policy, but its cumbersome communication framework also overly dominates market behavior.
However, the team of economists at Morgan Stanley pointed out in their latest report that even if Warsh takes office, the Federal Reserve's role in the financial markets is unlikely to undergo a dramatic shift. Led by Michael Gapen, the team of economists believes that if the Federal Reserve wants to substantially change its policy direction, it will not only take a long time but will also face insurmountable structural obstacles.
'The dilemma of slimming down'
Morgan Stanley clearly states that the Federal Reserve's short-term interest rate decision-making logic (Reaction Function) is unlikely to change due to a change in leadership. The core view is: 'The Federal Reserve's policy map is unlikely to shrink rapidly.'
Although the balance sheet strategy will evolve over time, its operational mechanism is extremely complex and closely tied to the structure of the banking system. Currently, the Federal Reserve has reduced its balance sheet from about $9 trillion to about $6.6 trillion. However, Morgan Stanley points out that this process has mainly been achieved by consuming overnight reverse repurchase (ON RRP) balances, while the scale of bank reserves, which are the cornerstone of the financial system, has remained basically unchanged.
The real challenge is that if the balance sheet continues to shrink, it will start to directly erode bank reserves, causing the financial system to slide from a 'plentiful' environment to a 'scarce' environment, thereby pushing up short-term financing rates.
Since the 2008 financial crisis, influenced by regulatory requirements such as the Liquidity Coverage Ratio (LCR) and internal stress tests, banks' demand for reserves has remained high. Morgan Stanley warns: 'Although regulatory reforms theoretically could reduce this demand, allowing the Federal Reserve to further shrink its balance sheet, it would come at the cost of sacrificing the financial system's risk resistance. There is no free lunch on this issue.'
Ten years of effort, difficult to complete the task
Aside from reserve limitations, the Federal Reserve's desire to revert its portfolio back to a 'national debt' configuration is bound to be a long process.
Since 2022, as mortgage rates soared, the speed of prepayments on agency mortgage-backed securities (MBS) has significantly slowed, leading to a marked deceleration in the process of passive balance sheet reduction. Morgan Stanley estimates that even assuming a significant drop in mortgage rates, the Federal Reserve could take nearly a decade to halve its MBS holdings solely through natural maturities and prepayments.
So, will there be proactive asset sales? Morgan Stanley believes the likelihood is extremely low. Proactively selling assets would not only widen spreads and drain liquidity, but could also impact housing affordability and lead to massive paper losses for the Federal Reserve. Therefore, the Federal Reserve still has a strong motivation to avoid taking this radical measure.
Market risk
Although major reforms are hindered, fine-tuning may still occur.
Economists point out that the Federal Reserve can adjust its balance sheet in coordination with the U.S. Treasury. Currently, the balance of the Treasury General Account (TGA) has swelled to nearly $1 trillion. If the TGA size is halved, the Federal Reserve could reduce its securities holdings without consuming bank reserves. Furthermore, the Federal Reserve may also shift its government bond portfolio towards short-term bonds by changing the maturity structure.
Looking ahead, Morgan Stanley believes that the threshold for using unconventional tools such as quantitative easing (QE) will significantly increase. Under the current policy preference, unless the economy falls into recession and leads interest rates to hit the zero lower bound, the Federal Reserve will not restart asset purchases.
It is worth noting that Walsh has always been averse to the Federal Reserve's 'chattering' communication style. Morgan Stanley predicts that if he takes office, the Federal Reserve may reduce the frequency of speeches and forward guidance. This means that investors will lose the policy 'crutch' and must rely more on real-time economic data for judgment. This shift could lead to increased market volatility and raise term premiums.
Morgan Stanley finally reminds investors: 'Although the overall policy direction is hard to change, the shift in market style is worth close attention.'
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