Fed’s balance sheet has some duration, for better or worse
It appears that, assuming the nominee for the next federal reserve chairman is confirmed by the
Senate, he is going to have to roll up his sleeves to achieve some of his monetary policy
priorities. Not that Kevin Warsh isn’t up to the task. He served on the fed’s board of governors
for five years, from 2006 to 2011, before returning to academia, and so has first-hand experience
into the workings of the board. This is unusual, but not unprecedented; two recent fed chairmen,
Ben Bernanke and Janet Yellen, served as governors, left, and returned to lead the fed.
What makes Warsh’s expected confirmation intriguing are his past words and actions regarding
the development and conduct of policy, juxtaposed with the fed’s current balance sheet position.
It could make for some interesting dialogue in upcoming meetings, and subsequent statements
and press conferences. Here’s some background.
First lap
Governor Warsh was known as an inflation hawk during his years at the fed, which coincided
with the start of, and the proceeding through, the Great Financial Crisis (GFC). He participated
in a shift of monetary policy from a restrictive stance to pop the real estate bubble in 2007,
hiking fed funds all the way to 5.50% in the process, to a wholly stimulative policy in which the
overnight rate dropped to 0.25% in barely over a year. The fed under Chairman Bernanke
initiated some novel strategies to keep the financial markets from seizing up. Included were the
first large-scale application of the massive bond-buying scheme known as “quantitative easing”
(QE).
So, within 24 months of being a fed governor, Warsh voted on tightening, easing, and the
purchase of over $1 trillion in government bonds. Along the way, he consented with the
chairman’s recommendations 100% of the time, which wasn’t unusual as most proposals were
unanimously approved by the Federal Open Market Committee (FOMC), of which each
governor is a member. Toward the end of his tenure, his speeches began to voice at least caution
in continued build-up of the balance sheet, indicating concern of over-stimulating an economy
that was already borrowing at effectively zero interest rates. While no means being radical,
Warsh was considered by most fed-watchers in the “hawk” category.
What’s transpired since
Fast forward a decade, to 2021. We had navigated past the GFC, only to be faced with the
COVID-19 pandemic. The fed, now under the chairmanship of Jay Powell, once again cut
overnight borrowing costs to near zero, and even more pertinently launched into another QE
phase that made all previous bond-buying escapades look timid. From March 2020 till August
2022, the fed added more than $4 trillion in bonds to its balance sheet, for the expressed purpose
of lowering the cost of borrowing for all of us. As it continued to buy at ever lower yields, the
fed’s escape route once the pandemic played out was always going to fraught with peril.
Since the balance sheet peaked at nearly $9 trillion in August 2022, the fed has run off over 25%
of its holdings. By “run off” I mean they’ve let short-term Treasury bonds simply mature,
without replacing them. The fed’s bond collection has had a “barbell” structure: lots of short
Treasuries and lots of very long mortgage-backed securities (MBS). As the shortest bonds have
gone away, and the very longest bonds are now more highly weighted, the average maturities
have correspondingly increased. Also, the MBS portfolio, which is nearly 1/3 rd of its holdings, is
dominated by very low coupons. Currently 93% of its MBS have stated interest rates of 3.5% or
lower.
Work to do
Why this matters: Warsh has written about his expectations to further shrink the balance sheet,
even though the organic cash flows have decreased. He has been quoted as saying, “by draining
as much as $2.5 trillion in excess reserves, the Fed would mitigate inflation,,,” So, it seems
relevant to investigate how quickly (or slowly) it will take for $2.5 trillion to roll off. Here’s the
tall task: The Treasury portfolio will shed about $2 trillion by 2031, and the MBS portfolio,
depending on prepayments, will shrink by about $200 billion per year.
So, if the fed simply sits on its current holdings, we’re looking at a multiyear proposition to get
the balance sheet to roughly $4 trillion. The alternative is to sell some of its holdings, which can
be easily accomplished as the portfolio consists of high-quality, highly liquid bonds. The rub is
interest rates likely would at least temporarily be under pressure to rise, as the supply would need
to be digested. That of course would be a means of ultimately keeping inflation under wraps, but
it’s hard to see how the FOMC could be in a rate-cutting cycle during this wind-down; it would
mean the fed would be injecting and removing stimulus simultaneously. Conundrum indeed.
Stay tuned! Chairman Warsh’s fed promises to deliver some headlines in 2026, and beyond.