BNY’s Americas Macro Strategist John Velis discusses how Federal Reserve (Fed) balance sheet reduction is moving up the agenda, with officials like Kevin Warsh and Stephen Miran favoring a smaller footprint achieved mainly via lower reserves. The piece also outlines BNY’s macro view that the Fed will cut rates in H2 2026, contingent on a cooling Middle East conflict, easing input prices and a weaker US labor market.

Fed balance sheet strategy and rate cuts

"The Fed’s balance sheet remains a hot topic that will only grow more so in the coming months. We have written frequently on both balance sheet dynamics and the level of reserves. Both issues, of course, are connected – given that the largest liability on the Fed’s balance sheet is reserves, exceeding even currency in circulation."

"Many Fed officials, including Fed chair nominee Kevin Warsh, have indicated a desire to reduce the size of the balance sheet in coming years. This would primarily be accomplished by reducing the supply of reserves in the system."

"The Fed’s concept of the balance sheet “trilemma” implies that a central bank can achieve a smaller balance sheet only if it either tolerates high money market volatility or engages in frequent open market operations to keep rates stable. Both Perli [NY Fed’s SOMA manager]  and Miran argue that another option, outside the trilemma, would be to reduce banks’ structural demand for reserves, allowing for a smaller balance sheet without stoking rate volatility."

"We maintain that the Fed will cut interest rates in H2 2026, although the market remains skeptical. On Monday, rate markets appeared to have “flipped” somewhat."

"To reiterate: under the (admittedly bold) assumption the conflict ebbs by midyear, and energy and other crucial input prices follow, we see a path to rate cuts. We don’t expect prices to return to pre-conflict levels, nor does our outlook require this."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)