As Middle East tensions and inflation outlook intertwine once again, two Federal Reserve governors spoke on Thursday the 26th, Eastern Time, releasing subtle but crucial policy signals. Governor Bowman explicitly pointed out that the conflict in Iran has caused inflation risks to once again outweigh employment. Governor Waller, meanwhile, shifted the discussion to a longer-term policy framework—emphasizing that balance sheet reduction will be a &#34;multi-year&#34; gradual process.
Overall, the Federal Reserve is simultaneously facing two main threads: short-term management of inflation uncertainty driven by energy shocks, and long-term redesign of its monetary policy operational framework, including banks' reserve requirements and balance sheet size. This &#34;dual-front battle&#34; suggests a potentially more complex future policy path.
<h2>Bowman: Iran Conflict Heightens Inflation Risks, Policy Leans Toward Caution</h2>
Fed Governor Bowman, speaking in Connecticut, stated directly that the current balance of risks has shifted, and compared to employment risks, inflation risks are now higher. In a Q&amp;A session following her speech, Bowman said:
<blockquote>
&#34;I think, due to the Iran war, current inflation risks are becoming higher. As for the labor market, I believe it is currently in a state of balance, but it is a precarious balance.&#34;
</blockquote>
She pointed out that the energy price shock from the Iran war, combined with previous tariff factors, is increasing the pressure for inflation to deviate from the 2% target. Media quoted her post-speech remarks stating that she believes inflation risks &#34;may persist longer than expected,&#34; meaning policymakers cannot afford to let their guard down.
In contrast, Bowman's assessment of the labor market was more cautious but still described it as balanced. She believes the labor market is generally in a &#34;state of balance, but this balance is fragile.&#34; Data shows that U.S. job growth has continued to slow, with insufficient hiring momentum, but no significant deterioration has occurred yet.
In terms of policy implications, this assessment means the Federal Reserve will rely more on data for its interest rate path while remaining highly sensitive to upside inflation risks. Especially against the backdrop of oil price shocks, policymakers may be more inclined to &#34;stay the course&#34; rather than hastily pivoting to easing.
<h2>Waller: Balance Sheet Reduction May Take Years, Potentially Cutting $1-2 Trillion in Assets</h2>
Unlike Bowman, who focused on short-term inflation, Governor Waller focused on the long-term adjustment of the Federal Reserve's balance sheet.
In his latest speech and working paper, he stated that the Federal Reserve has the capacity to significantly reduce its current balance sheet of approximately $6.7 trillion, but this process &#34;will likely take years&#34; and must be phased.
Waller estimates that under the current operational framework, if the demand for reserves by banks can be lowered, the Fed's asset size could be reduced by $1 trillion to $2 trillion. However, he emphasized that this premise itself requires policy adjustments, such as:
<ul>
<li>Relaxing regulatory requirements like the Liquidity Coverage Ratio (LCR) for banks</li>
<li>Eliminating the &#34;stigma&#34; associated with banks using the discount window and the standing repo facility</li>
<li>More proactive open market operations at key times like quarter-end</li>
<li>Enhancing the liquidity attractiveness of alternative assets like Treasury bills</li>
</ul>
He explicitly stated that &#34;it will still take some time before we truly start reducing the balance sheet&#34; until these preparatory measures are completed.
<h2>&#34;Slow is Fast&#34;: Balance Sheet Reduction Needs Coordination with Interest Rate Policy to Avoid Market Shocks</h2>
Waller particularly emphasized that the balance sheet reduction process must be &#34;very slow&#34; to allow financial markets time to adapt. He frankly stated, &#34;It is difficult to overstate the importance of proceeding slowly.&#34;
More crucially, he pointed out that reducing the balance sheet itself has a tightening effect, and thus may require hedging through &#34;more interest rate cuts than in the baseline scenario.&#34; This statement implies that the future policy mix might involve a parallel approach of &#34;balance sheet reduction + interest rate cuts.&#34;
On an institutional level, he also cautioned that if the Federal Reserve returns to the &#34;scarce reserves&#34; system from before the financial crisis, it will inevitably come with the cost of increased short-term interest rate volatility.
Regarding the final target size, Waller believes returning to pre-financial crisis levels is &#34;unrealistic,&#34; but suggests considering controlling the balance sheet to around 15%-18% of GDP (pre-pandemic levels), while the current ratio is still above 20%.

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Governor Bowman stated that the current balance of risks has shifted, with inflation risks "now higher" than employment risks. She believes inflation risks "may persist longer than expected." Waller estimates that under the current operational framework, the Fed's asset size could be reduced by $1 trillion to $2 trillion if banks' demand for reserves is lowered. He emphasized that the balance sheet reduction process must be "very slow" to allow financial markets time to adapt, and it needs to be coordinated with interest rate policy to avoid market shocks

- Recent comments from two Federal Reserve governors highlight shifting policy signals amid the Middle East situation and inflation concerns.  
- Governor Cook indicated that inflation risks are now surpassing employment risks due to the Iranian conflict, while Governor Milan focused on a long-term framework for gradually reducing the Fed's balance sheet, which may take several years.  
- This dual approach suggests that the Fed is navigating both short-term inflation uncertainty and the redesign of monetary policy, potentially complicating future policy directions.

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Fed Governors: Iran Conflict Poses Inflation Risk Over Jobs, Balance Sheet Reduction May Take Years