Fed Reserve Weighs Balance Sheet Reduction and Future Interest Rate Hikes

Federal Reserve Governor Christopher Waller suggested that the central bank could reduce the size of bank reserves from the current $3.26 trillion to around $2.7 trillion. This adjustment, coupled with the Fed's holdings of currency in circulation and the Treasury Department's General Account balance, would bring the overall balance sheet size to $5.8 trillion, down from the current $6.7 trillion.

Regarding interest rates, Waller reiterated his view that the current federal funds rate is too restrictive and that a rate cut could be appropriate as early as the next meeting later this month. He acknowledged that his view is in the minority among his colleagues, but maintained that his support for a rate cut is not politically motivated.

Former President Trump and numerous officials in his administration have repeatedly called for the Fed to cut interest rates. White House National Economic Council Director Kevin Hassett criticized the Fed for “falling behind the curve” by not cutting rates like other central banks.

Notably, Waller is on the short list of candidates to become the next Chairman of the Federal Reserve.

Speaking at an event hosted by the Dallas Fed, Waller emphasized that the Fed should continue to reduce the size of its balance sheet, but not as drastically as some Fed watchers and economists have suggested. He stated that allowing maturing and prepaid securities to gradually roll off the balance sheet would reduce reserve balances.

Determining the minimum level of “ample” reserves is crucial for assessing how far the Fed can shrink its balance sheet without disrupting overnight money markets.

According to the latest Fed data, total commercial bank reserves at the Fed currently stand at $3.26 trillion. Wall Street strategists expect the Fed needs to keep reserves above $3 trillion to $3.25 trillion to maintain ample liquidity and avoid market stress.

Waller differs from his colleagues in his willingness to provide a specific number for the level of “ample” reserves.

Some critics of the Fed’s balance sheet expansion have argued that it should be shrunk back to pre-financial crisis levels. During the financial crisis, the Fed expanded its balance sheet from around $800 billion to over $2 trillion by purchasing Treasury bonds and mortgage-backed securities.

Waller also suggested that the Fed should adjust the structure of its balance sheet to hold more short-term assets, with long-term securities serving as a hedge against monetary liabilities.

He noted that some market participants argue that the Fed’s balance sheet composition should mirror the structure of the Treasury market itself, with 20% allocated to short-term assets.

Waller concluded, “That’s a reasonable point, but it would increase the duration of our balance sheet and expose the Fed to potential income losses, as we’ve seen in the past few years.”