Analysts with Morgan Stanley believe an abrupt shift in the Federal Reserve’s role in financial markets under a possible Kevin Warsh chairmanship is unlikely.
Investing.com stated that while Warsh’s nomination has refocused attention on the Fed’s balance sheet and communications strategy, a meaningful change would take time and face significant structural constraints, the analysts stated in a note.
They noted that Warsh has been critical of what he believes is an excessively large central bank footprint, pointing not only to the size of its asset holdings, but also to blurred lines between monetary and fiscal policy and an increasingly heavy communication framework that drives market behavior.
Morgan Stanley said it does not expect Warsh’s nomination to materially alter the Fed’s near-term interest rate reaction function.
“We think a rapid shift in the Fed’s footprint is unlikely,” the economists led by Michael Gapen said. He noted that while balance sheet strategy could evolve over time, the mechanics of doing so are complex and tightly linked to the structure of the banking system.
A key constraint is reserve demand, Investing.com said. Economists said the Fed has already reduced its balance sheet from roughly $9 trillion to about $6.6 trillion largely via a decline in overnight reverse repo balances, with bank reserves remaining broadly unchanged.
More reductions from here would begin to erode reserves, Investing.com said, pushing the system from an “ample” to a “scarce” environment and potentially putting upward pressure on short-term funding rates, the economists said.
As a result, they said, any meaningful shrinkage of the balance sheet likely would require a reduction in banks’ demand for reserves, which has been elevated since the financial crisis due to post-2008 liquidity regulations such as the Liquidity Coverage Ratio and internal liquidity stress tests.
Although reforms could ease that demand, the economists stated, they would come with trade-offs for financial system resilience, the economists noted.
“Altering liquidity requirements may reduce demand for reserves and permit a smaller Fed balance sheet, but reduced liquidity buffers could impair financial system resilience in periods of stress. There is no free lunch,” the economists wrote.
Returning the Fed’s portfolio to an all-Treasury composition is also expected to be slow. With mortgage rates having risen sharply since 2022, prepayment speeds on agency mortgage-backed securities (MBS) have dropped, significantly slowing passive runoff.
Morgan Stanley estimates it could take close to a decade for the Fed to cut its MBS holdings in half via runoff alone, even assuming a substantial decline in mortgage rates.
Because active asset sales could widen spreads, depress liquidity, hurt housing affordability, and generate mark-to-market losses, economists said the central bank continues to have strong incentives to avoid them.
Some balance sheet adjustments could occur through coordination with the U.S. Treasury, Investing.com said. The Treasury General Account has grown to almost $1 trillion since the financial crisis and the COVID period, and economists said cutting it in half could allow the central bank to reduce securities holdings without draining reserves.
Changes to the maturity profile of the Fed’s Treasury portfolio also could support a gradual shift toward shorter-dated holdings, Investing.com said.
Looking ahead, the Fed said there is now a higher bar for future quantitative easing and unconventional policy tools.
Under current preferences, the Morgan Stanley economists said they expect asset purchases to return only in recessionary conditions that push rates to the effective lower bound, with reserve-management purchases used more sparingly.
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