Deep Dive into the Fed's Landmark 'Balance Sheet Reduction' Paper: How Much, How, and What Impact?

Tuesday evening at 10 p.m. Beijing time, the U.S. Senate Banking Committee will hold a hearing on Kevin Warsh's nomination as Fed Chair. This marks Warsh's first formal appearance on Capitol Hill to systematically articulate his monetary policy views. Of particular note is Warsh's long-standing critical stance on the Fed's massive balance sheet; this hearing may become an important platform for expressing these views. In fact, since late 2025, the trajectory of the Fed's balance sheet has remained a core issue closely watched by global financial markets. Against this backdrop, Federal Reserve Governor Stephen Miran, alongside three other Fed economists, recently co-released a working paper titled "A User Guide to Reducing the Federal Reserve's Balance Sheet." On March 26, 2026, they systematically explained the Fed's strategic logic and potential paths for balance sheet reduction during a keynote speech at the Miami Economic Club. The core value of this paper lies in breaking conventional market perceptions. In the past, markets generally believed that "the ceiling for Fed balance sheet reduction is exhausted reserves." However, the paper points out that reserve demand itself can be shaped by policy—through adjustments to a series of regulatory and operational frameworks, the Fed is entirely capable of achieving significant balance sheet slimming while maintaining the framework of 'ample reserves'. Following this, the CITIC Securities research team conducted a deep analysis. Their judgment is: technical options such as relaxing LCR standards, reforming SRP, and upgrading Fedwire possess certain feasibility; however, schemes like reserve tiering, reforming TGA, and adjusting the foreign reverse repo pool are relatively idealistic. Overall, the balance sheet reduction process is unlikely to alter the underlying logic of central banks globally purchasing gold. CITIC Securities maintains its judgment of a 25 basis point rate cut by the Fed in the second half of this year. Why Reduce the Balance Sheet: Miran's List of Reasons In his Miami speech, Miran straightforwardly presented multiple reasons for reducing the Fed's balance sheet. First, reduce market distortions. An excessively large Fed balance sheet creates unnecessary intervention in money markets and exacerbates the problem of financial intermediation disintermediation. Minimizing the Fed's "footprint" in the market is a basic requirement for maintaining the market's price discovery function. Second, control financial risks. Large-scale asset holdings imply greater exposure to mark-to-market losses and lead to increased volatility in profits remitted to the Treasury. In recent years, the Fed has faced pressure from floating losses due to holding a large amount of long-duration securities; this issue can no longer be ignored. Third, safeguard the boundary between monetary and fiscal policy. The massive balance sheet objectively involves the Fed in credit resource allocation, blurring the lines between monetary and fiscal policies. Additionally, paying large-scale interest on bank reserves has been viewed by some members of Congress as an implicit subsidy to financial institutions. Fourth, preserve policy ammunition. If the next crisis of the zero lower bound arrives, the Fed will need to expand its balance sheet to provide room for easing. Compressing the balance sheet to a reasonable size now preserves necessary room for future policy maneuvering. Miran admitted that the outside world generally considers large-scale balance sheet reduction "simply impossible." But his judgment is entirely different: "Balance sheet reduction is a challenge that can be solved; those who flatly deny it simply lack imagination." Key Diagnosis: It's "Demand," Not "Supply," That Stalls Reduction To understand this discussion, one must first clarify a logic structure that has long been misread. The traditional framework holds that the constraint on Fed balance sheet reduction comes from "reserve supply touching the steep region of the demand curve"—once supply tightens to a critical point, overnight rates will spiral out of control. Therefore, the Fed can only wait until reserves drop to a "scarce" state before passively stopping balance sheet reduction. The "repo market earthquake" in September 2019 was a real-world enactment of this logic. The breakthrough of the paper lies in shifting the perspective from the "supply side" to the "demand side." The paper points out that reserve demand is not an exogenous constraint "naturally determined" by payment and settlement activities, but rather artificially elevated by regulatory rules, enforcement interpretations, and the Fed's own operational framework—Miran refers to this phenomenon in the paper as "regulatory dominance" over the Fed's balance sheet. Specifically, the following three mechanisms jointly push up the reserve demand baseline: 1. Spreads turn reserves into "lazy earning assets." After the Fed began paying interest on reserves (IOR) starting in 2008, reserves transformed from pure settlement necessities into assets that compete with Treasury bills. There have been periods historically where the interest rate on reserves (IORB) exceeded the yields of 1-month or 3-month Treasuries; from a risk-return perspective, banks preferred to hoard reserves. 2. Multiple liquidity regulations create a "ratchet effect." Rules such as LCR (Liquidity Coverage Ratio), ILST (Internal Liquidity Stress Test), RLEN (Resolution Liquidity Assumptions), NSFR (Net Stable Funding Ratio), and SLR (Supplementary Leverage Ratio) intertwine, creating a dilemma of "robbing Peter to pay Paul"—changing one rule immediately causes another to step up as a new binding constraint. 3. Long-term "stigmatization" of the Discount Window. High discount window rates, historical association with "troubled banks," and the risk of disclosure and regulatory scrutiny regarding usage records lead banks to hoard reserves rather than utilize policy tools during liquidity stress periods. The same stigmatization logic has spread to the Standing Repo Facility (SRP). This diagnosis implies a fundamental policy path: there is no need to wait for reserves to return to a scarce state; instead, by lowering the "scarce–ample" threshold, the ample reserves framework can continue to operate normally under a much smaller balance sheet scale. How Much Can Be Reduced: Quantitative Estimates from $1.2 Trillion to $2.1 Trillion The paper uses the Fed's H.4.1 report data as of March 11, 2026, as a benchmark, when total Fed assets were approximately $6.646 trillion. The liability structure breakdown is as follows: reserves approximately $3.073 trillion, currency in circulation $2.390 trillion, Treasury General Account (TGA) approximately $806 billion, and foreign reverse repo pool approximately $325 billion. The paper conducts quantitative estimates around two major directions and 15 policy options, but the most crucial aspect is its refusal to simply sum them up. Due to correlations and substitutability among different policies, the paper employs Monte Carlo aggregation methods under the OMB A-4 framework, yielding the following confidence intervals: Dimension 95% Confidence Interval Median Potential Reduction in Reserve Demand $825 Billion - $1.75 Trillion Approximately $1.287 Trillion Potential Total Balance Sheet Reduction $1.15 Trillion - $2.125 Trillion Approximately $1.637 Trillion Miran compared the above interval with historical reference points in his speech: 15% of GDP: The balance sheet level after the end of the first round of QE in 2009, when the banking system could still operate normally; 18% of GDP (levels of 2012 or 2019): Reflecting the actual liquidity demands of the banking system after Basel reforms and Dodd-Frank Act requirements became clearer. Currently, the Fed's balance sheet accounts for about 21% of GDP. According to the paper's median estimate, if reforms proceed smoothly, the balance sheet could fall back to relative levels close to 2012 or 2019. As for whether it can return to pre-crisis levels below 10% of GDP—Miran explicitly stated: "Unrealistic and unnecessary." How to Reduce: A "Menu-Based" Analysis of 15 Options The paper categorizes the 15 policy tools into two major types, providing estimated effect ranges and execution prerequisites for each. Category 1: Lower Equilibrium Reserve Demand (I) Regulatory Reform Level LCR Reform (Liquidity Coverage Ratio): The core measure allows banks to count financing capabilities corresponding to non-HQLA loans pre-collateralized at the Discount Window towards HQLA, setting a cap. The paper estimates the impact on reserve demand to range from $50 billion to $450 billion. It also warns that if only LCR is changed, NSFR may immediately step up as a new binding constraint, requiring holistic consideration. ILST and Resolution Liquidity Assumptions (RLEN): If regulators recognize Discount Window capacity and short-term liquidity sources, ILST reform could bring a $50 billion to $200 billion decrease in reserve demand; if RLEN extends the time window assumption for Discount Window availability, the estimated range is $0 to $100 billion. (II) Supervisory Interpretation Level If banks hold excess reserves to cater to examiner preferences (i.e., T-bills and reserves are not treated equally from a supervisory perspective), the magnitude of adjustment is estimated at $25 billion to $50 billion. This is a reform achievable without modifying regulations, relying solely on a shift in supervisory culture, but the difficulty of implementation should not be underestimated. (III) Reduce Returns on Reserve Holdings Allow the Effective Federal Funds Rate (EFFR) to exceed IORB, i.e., break the current state where EFFR is persistently lower than IORB. Citing the Lopez-Salido and Vissing-Jorgensen (2025) framework, the paper estimates that if the reference is "EFFR-IORB = +2bp" (close to September 2019 stress levels), the corresponding reserve demand decrease range is $150 billion to $550 billion. However, this path carries obvious costs: volatility in overnight rates and repo rates will increase significantly, and if the market increases precautionary hoarding as a result, the demand reduction effect may be partially offset. Walking this path requires supporting mechanisms such as SRP and Temporary Open Market Operations (TOMO). (IV) Enhance Attractiveness of Alternative Assets Includes upgrading the Fedwire system, improving Treasury market liquidity, and advancing central clearing. The goal is to make alternative assets like Treasuries more attractive to banks, closer to reserves. These measures also help improve the private sector's ability to absorb securities released during the Fed's balance sheet reduction. (V) De-stigmatize Fed Liquidity Tools By eliminating concerns about using tools like the Discount Window, Standing Repo Facility, and intraday overdrafts, reduce banks' precautionary reserve demand. This requires systematic coordination from the Fed in transparency, pricing mechanisms, and regulatory communication. Category 2: Directly Reduce Non-Reserve Liabilities (I) Re-calibrate TGA Management Reduce the cash buffer for the Treasury in the Fed account from "approximately 5 days of operating funds" to "approximately 2 days," transferring the excess back to the commercial banking system (similar to historical TT&L arrangements). The estimated reduction for the Fed's balance sheet is $200 billion to $400 billion. The paper also acknowledges that since deposits flowing back to banks will correspondingly raise banks' demand for reserves, the net effect is not one-to-one. (II) Reduce Attractiveness of Foreign Reverse Repo Pool By lowering interest payments and setting size caps, guide foreign central banks, sovereign wealth funds, and other institutions to move funds from the Fed's reverse repo pool to the U.S. Treasury market. The estimated range is $0 to $100 billion; the effect is relatively limited and depends on the willingness of external institutions to cooperate. Warsh's Signal: From Technical Paper to Policy Expectations Understanding this paper cannot be separated from the Fed's personnel background. Markets widely expect Warsh to succeed as Fed Chair. Warsh has long held a critical attitude toward the Fed's balance sheet expansion policies since QE began and has publicly expressed a preference for reducing the balance sheet on multiple occasions. This working paper led by Miran is viewed by outsiders as a forward-looking signal for the Fed's policy orientation in the future "Warsh Era." CITIC Securities research team points out that given Warsh's stance and the potential space revealed by this paper, the Fed in the "Warsh Era" indeed exists with the possibility of gradually exploring a restart of balance sheet reduction. However, both the paper and the speech repeatedly emphasize that speed and rhythm are the most critical constraints at the execution level. Miran explicitly stated in his speech: "Once the preparation work for reform begins, following the government's usual rhythm through the Administrative Procedure Act (APA), it will likely take more than a year, even several years." He cited SLR (Supplementary Leverage Ratio) reform as a reference—from temporary relaxation to formal regulation landing took nearly six years. This means the Fed will not immediately restart balance sheet reduction due to the publication of this paper in the short term. A more likely path is to begin promoting research from options with less controversy and technical feasibility, while providing forward-looking guidance to the market on how the new mechanism operates. CITIC Interpretation: Which Are Feasible, Which Are Idealistic From the perspective of practical feasibility, the CITIC Securities research team conducted a systematic assessment of the 15 policy options, reaching the following core judgments: Options with Practical Feasibility: Relaxing LCR Standards: Belongs to technical regulatory reform with relatively controllable variables and significant Fed reform initiative; Reforming the Standing Repo Facility (SRP): De-stigmatization work is relatively direct and does not involve external legislation; Upgrading Payment Systems like Fedwire: Belongs to long-term improvements at the infrastructure level with clear direction; Adjusting ILST Supervisory Interpretation: Some reforms do not require legislative changes and can be advanced through shifts in supervisory culture. Options That Are Relatively Aggressive or Require External Cooperation: Tiered Interest Payments on Reserves: May trigger non-linear reactions in the banking system, making operations complex; TGA Management Reform: Involves coordination mechanisms between the Treasury and the Fed, requiring political consensus; Reducing the Foreign Reverse Repo Pool: Highly dependent on the willingness of external institutions to cooperate, making results difficult to guarantee. Overall, CITIC Securities believes this is "a reform menu worth referencing and relatively pragmatic," but actual implementation progress will be far slower than the potential upper limit depicted in the paper. It should be viewed as directional guidance rather than a near-term policy commitment. Market Impact: Increased Volatility, But No Change to Rate Cut Logic Regarding the bond market, the essence of Fed balance sheet reduction is reducing base money issuance, which inevitably increases the scale of U.S. Treasuries the private sector must absorb. CITIC Securities believes this will amplify market volatility and slightly increase tail risks—although some de-regulation measures (such as SLR relaxation) help expand dealers' absorption capacity. From a scheduling perspective, the paper explicitly opposes accelerating balance sheet reduction through direct security sales. A more feasible approach is to let maturing securities naturally roll off the balance sheet while providing higher absorption capacity reserves for dealers and the repo market. This objectively limits the short-term shock intensity of balance sheet reduction. CITIC Securities judges that U.S. Treasuries currently offer better trading opportunities, with short-term bonds potentially outperforming long-term bonds. Regarding the stock market, balance sheet reduction exerts a contractionary effect on the real economy through two paths: money supply and portfolio balance effects, but this can be offset by lowering the federal funds rate. CITIC Securities believes that if balance sheet reduction reforms advance, the necessity for corresponding adjustments in the interest rate path rises, but this has limited direct connection to the current monetary policy rhythm. U.S. stocks may wait for a correction window to find a thicker safety margin. Regarding the gold market, balance sheet reduction reforms are unlikely to substantially change the strategic logic of global central banks increasing gold holdings; the latter's drivers stem more from geopolitical restructuring and trends toward dollar reserve diversification. Gold retains medium-to-long-term allocation value. Miran explicitly stated in his speech that the contractionary effects generated by balance sheet reduction can be offset by rate cuts, and "balance sheet reduction may cause the decline in the federal funds rate to be relatively larger compared to the baseline scenario." CITIC Securities expects U.S. CPI year-over-year to oscillate within the 3.0% to 3.5% range this year, maintaining its judgment of a 25 basis point rate cut by the Fed in the second half of the year. Balance sheet reduction reforms and rate cut decisions are not directly bound.