---
title: "Federal Reserve's Balance Sheet Reduction: How Significant is the Impact?"
description: "Morgan Stanley's latest research report points out that the Federal Reserve's reduction of its balance sheet is technically feasible, but the process will proceed slowly, primarily relying on passive "
type: "news"
locale: "en"
url: "https://longbridge.com/en/news/275352633.md"
published_at: "2026-02-09T18:36:03.000Z"
---

# Federal Reserve's Balance Sheet Reduction: How Significant is the Impact?

> Morgan Stanley's latest research report points out that the Federal Reserve's reduction of its balance sheet is technically feasible, but the process will proceed slowly, primarily relying on passive balance sheet reduction. As reverse repos are essentially exhausted, future balance sheet reduction will more reflect a decline in bank reserves, which may affect market liquidity. However, whether long-term interest rates rise still depends on the Treasury's debt issuance structure, rather than the balance sheet reduction itself

How the Federal Reserve will reduce its balance sheet in the future is becoming a focal point of market attention. Morgan Stanley pointed out in its latest research report that changes in the size of the balance sheet may have more far-reaching effects compared to adjustments in policy interest rates, but the entire process will be very slow and subject to various technical constraints and market trade-offs.

The report believes that the current balance sheet reduction mainly relies on "passive reduction," which means not reinvesting in U.S. Treasury bonds and mortgage-backed securities after they mature. This method has already reduced the Fed's assets by more than $2 trillion since 2022 and may continue to be the primary path in the future. However, as reverse repurchase tools are basically exhausted, further balance sheet reduction will increasingly directly reduce bank reserves, which will have a more noticeable impact on the liquidity of the financial system.

**The most concerning question for the market is whether balance sheet reduction will push up interest rates. Morgan Stanley's judgment is: not necessarily.** The key lies in how the U.S. Treasury issues new debt. If more financing is done through short-term Treasury bills rather than increasing the issuance of long-term interest-bearing Treasury bonds, then the upward pressure on long-term interest rates may be limited.

## Two Paths for Balance Sheet Reduction: Passive Maturity and Active Sale

The report points out that the Federal Reserve has two main ways to reduce its balance sheet: one is passive reduction, which means not reinvesting after securities mature; the other is actively selling assets in the market.

Currently, passive reduction remains the most realistic path. Actively selling assets, especially MBS, is quite challenging, as this could lead to widening spreads and further worsen housing affordability. Therefore, the threshold for the Fed to actively sell MBS is very high.

At the current pace, it may take nearly ten years for the Fed's MBS holdings to be reduced by half, indicating that the balance sheet reduction process itself will be very slow.

## The Real Constraint: Bank Reserves and Liquidity

The key limitation for further balance sheet reduction does not lie on the asset side, but on the liability side.

As the scale of reverse repos declines, future balance sheet shrinkage will increasingly depend on the decrease in bank reserves. However, banks have a strong demand for reserves, such as regulatory requirements like the Liquidity Coverage Ratio (LCR) and internal liquidity management rules.

If reserves decline significantly, the liquidity conditions in the financing market may tighten, and the volatility of the federal funds rate and repo rates may increase, potentially exceeding the reserve interest rate. To prevent significant fluctuations in market interest rates, the Fed may need to use more temporary open market operations to adjust liquidity.

## A Technical Solution: Shrinking the Balance Sheet Without Reducing Reserves

The report also proposes a technical possibility: to shrink the balance sheet through coordination between the Treasury and the Fed without reducing bank reserves.

For example, the Treasury could lower its balance in the Fed's General Account (TGA). If the TGA scale decreases, the Fed could reduce its holdings of U.S. Treasury bonds by the corresponding amount, thereby shrinking the balance sheet while keeping bank system reserves unchanged.

This method could also reduce the interest expenses the Treasury pays to the Fed, but it requires a high degree of policy coordination.

## Will Balance Sheet Reduction Push Up Long-Term Interest Rates? The Key Lies with the Treasury

The market is generally concerned that balance sheet reduction means an increase in bond supply, which would push up yields, especially long-term rates. However, the report suggests that this relationship is not necessarily the case.

If the balance sheet reduction is achieved through passive maturities, then the new supply is actually completed through Treasury refinancing, and the term structure of government bonds is determined by the Treasury, not the Federal Reserve.

If the Treasury continues to favor issuing short-term Treasury bills rather than expanding long-term government bond issuance, then the long-term bond supply that the market needs to absorb will not significantly increase, and the upward pressure on long-term rates may also be limited.

Overall, the Federal Reserve's balance sheet reduction is technically entirely feasible, but the process will advance slowly and be constrained by multiple factors such as bank reserve demand, market liquidity, and the Treasury's debt issuance structure. For the market, what is truly worth paying attention to is not just the balance sheet reduction itself, but also the changes in liquidity environment and interest rate structure during the balance sheet reduction process

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> **Disclaimer**: This article is for reference only and does not constitute any investment advice.