NEW YORK: Wall Street strategists expect a group of senior academics and former policymakers assembled by chairman Kevin Warsh to review the Federal Reserve’s (Fed) US$6.7 trillion balance sheet will face a difficult balancing act: shrinking the central bank’s holdings without destabilising funding markets.
While the group’s academic heft lends credibility to the process, the lack of market experts among its members could result in solutions that are good in theory but difficult to implement, some of them warned.
Warsh last week announced the leadership of five task forces that will examine the Fed’s approach to key aspects of policy making, from inflation to communications, potentially leading to sweeping changes.
But for investors, the balance sheet review could be the most consequential.
“That is clearly an area with the Fed where Warsh has focused a lot of his attention”, and “it’s going to have the most salient impact on markets”, Ed Al-Hussainy, portfolio manager at Columbia Threadneedle said.
The group, led by former Fed governor and Harvard University economics professor Jeremy Stein, former Reserve Bank of India governor and University of Chicago Booth School of Business finance professor Raghuram Rajan and Harvard University economics professor Karen Dynan, will be tasked with finding ways to pare back the Fed’s market footprint, which Warsh has long criticised.
Analysts said they will have to confront more than that, including how the central bank will respond to future crises that prompted successive rounds of asset purchases in the past, most notably in September 2019 when short-term interest rates skyrocketed, and again in March 2020 when the treasuries market seized up at the start of the pandemic-induced dash for cash.
“The capacity to reduce the balance sheet is fairly limited,” said Joseph Abate, head of US rates strategy at SMBC Nikko Securities America.
“The Fed’s behaviour since 2019, shows the Fed doesn’t have any tolerance for repo rates trading high.”
At stake is the smooth functioning of the financial market plumbing that underpins the treasury market, where cash‑rich institutions such as money market funds lend short‑term capital and investors, including hedge funds, borrow against high quality collateral to fund strategies like the popular basis trade.
The concern is that shrinking the balance sheet too far could drain liquidity and spur volatility, undermining the Fed’s ability to control its rate‑setting tools and, in a worst case scenario, force position unwinds that spill into the broader treasury market, the global benchmark for borrowing costs.
The group’s policy credentials and diverse backgrounds offer confidence, strategists said.
Stein brings a financial stability framework shaped inside the Fed during his governorship from 2012 to 2014, while Raghuram has long warned about banks becoming too dependent on central bank liquidity.
Dynan adds technocratic policy experience, having served as chief economist at the Treasury Department.
“It’s credible economists who can lean on the Fed staff to figure out how to reduce the balance sheet,” Brij Khurana, portfolio manager at Wellington Management, said. — Bloomberg
