In-Depth Analysis of the Federal Reserve's Major "Balance Sheet Reduction" Paper: How Much to Shrink, How to Shrink, and What Are the Impacts?

Author: Zhao Ying, Wall Street Insights

At 10 p.m. Tuesday Beijing time, the U.S. Senate Banking Committee will hold a hearing on Kevin Waugh’s nomination for Federal Reserve Chair. This is Waugh’s first formal occasion on Capitol Hill to systematically articulate his monetary policy views. Notably, Waugh has long been critical of the Fed’s massive balance sheet, and this hearing may serve as an important platform for him to express related views.

In fact, since the end of 2025, the direction of the Fed’s balance sheet has been a core topic of high concern in global financial markets. Against this backdrop, Fed Governor Stephen Milam, together with three Fed economists, recently published a working paper titled “A User’s Guide to Shrinking the Fed’s Balance Sheet,” and on March 26, 2026, during a keynote speech at the Miami Economic Club, systematically explained the strategic logic and potential pathways for the Fed to reduce its balance sheet.

The core value of this paper lies in breaking the market’s usual understanding. Historically, the market generally believed that “the ceiling for Fed balance sheet reduction is the depletion of reserves.” But the paper points out that reserve demand can itself be shaped by policy—through a series of regulatory and operational framework adjustments, the Fed could significantly shrink its balance sheet while maintaining a “sufficient reserves” framework.

In response, the Citic Securities research team provided an in-depth interpretation. They judge that: relaxing the LCR standards, reforming SRP, and upgrading Fedwire are technically feasible options; however, layered reserves, reforming TGA, and foreign reverse repurchase pools are more idealistic. Overall, the process of balance sheet reduction is unlikely to change the underlying logic of global central banks’ gold purchases. Citic Securities maintains its view that the Fed will cut interest rates by 25 basis points in the second half of this year.

Why reduce the balance sheet: Milan’s list of reasons

In his Miami speech, Milan straightforwardly presented multiple reasons for shrinking the Fed’s balance sheet.

First, to reduce market distortions. An excessively large balance sheet distorts the funding markets unnecessarily and exacerbates disintermediation issues in finance. Minimizing the Fed’s footprint in the market is a fundamental requirement for maintaining proper price discovery.

Second, to control financial risks. Large asset holdings mean greater exposure to market value losses and cause fluctuations in remittances to the Treasury. Recently, the Fed has been under pressure from unrealized losses due to holding long-duration securities, which is an issue that can no longer be ignored.

Third, to safeguard the monetary-fiscal boundary. A huge balance sheet objectively allows the Fed to intervene in credit resource allocation, blurring the line between monetary and fiscal policy. Additionally, paying large amounts of interest on reserves has been viewed by some Congress members as a hidden subsidy to financial institutions.

Fourth, to retain policy ammunition. If the zero lower bound crisis occurs again, the Fed will need to expand its balance sheet to provide room for easing. Now, compressing the balance sheet to a reasonable size is to leave room for future policy adjustments.

Milan admits that the public generally believes that large-scale balance sheet reduction is “impossible.” But he holds a very different view: “Balance sheet reduction is a solvable challenge; those who categorically deny it simply lack imagination.”

Key diagnosis: Demand, not supply, is the bottleneck for balance sheet reduction

To understand this discussion, one must first clarify a long-misinterpreted logical structure.

The traditional view holds that the constraint on Fed balance sheet reduction comes from “reserve supply hitting the steep part of the demand curve”—once supply tightens to a critical point, overnight rates will spiral out of control. Therefore, the Fed can only passively stop shrinking once reserves become “scarce.” The September 2019 “repo market shock” was a real-world illustration of this logic.

The breakthrough in the paper is shifting the perspective from the “supply side” to the “demand side.” It points out that reserve demand is not an exogenous constraint naturally determined by payment activities but is artificially elevated by regulatory rules, supervisory interpretations, and the Fed’s operational frameworks—what Milam calls “regulatory dominance” over the balance sheet.

Specifically, three mechanisms jointly push up the baseline reserve demand:

1. The interest rate differential makes reserves a “riskless earning asset.” After the Fed started paying interest on reserves (IORB) in 2008, reserves transformed from mere settlement necessities into assets competing with Treasury bills. Historically, periods when the reserve interest rate (IORB) exceeded the 1- or 3-month Treasury yield saw banks prefer holding reserves for risk-adjusted returns.

2. Multiple liquidity regulations create a “ratchet effect.” Rules like LCR, ILST, RLEN, NSFR, and SLR intertwine, forming a “whack-a-mole” dilemma—changing one rule immediately makes another a new binding constraint.

3. The long-standing “stigma” of the discount window. Its high rate, historical association with “problem banks,” and regulatory scrutiny discourage banks from using it, leading them to hoard reserves instead of deploying policy tools during liquidity stress. The same stigma extends to the Standing Repo Facility (SRP).

This diagnosis suggests a fundamental policy path: instead of waiting for reserves to become scarce, lower the boundary between “scarcity” and “adequacy,” allowing a “sufficient reserves” framework to operate normally at a smaller balance sheet size.

How much can be reduced: an estimated range of $1.2 trillion to $2.1 trillion

Using the Fed’s H.4.1 report data as of March 11, 2026, when total assets were about $6.646 trillion, the breakdown of liabilities was approximately: reserves $3.073 trillion, currency in circulation $2.39 trillion, the Treasury General Account (TGA) about $806 billion, and foreign reverse repo pool about $325 billion.

The paper performs quantitative estimates across 15 policy options in two main directions, but importantly, it does not simply sum them up. Due to correlations and substitutability among policies, it uses a Monte Carlo aggregation under the OMB A-4 framework to derive confidence intervals:

Milam compares these ranges with historical reference points:

• 15% of GDP: the balance sheet level after the first round of QE in 2009, when banks still operated normally;
• 18% of GDP (2012 or 2019 levels): reflecting the true liquidity needs of banks after Basel reforms and Dodd-Frank.

Currently, the Fed’s balance sheet is about 21% of GDP. Based on the median estimate, if reforms proceed smoothly, the balance sheet could fall back to levels similar to 2012 or 2019. As for returning below 10% of GDP before the crisis—Milam explicitly states: “That’s unrealistic and unnecessary.”

How to shrink: “Menu-style” analysis of 15 options

The paper categorizes the 15 policy tools into two groups, providing effect ranges and implementation assumptions for each.

First group: Lowering equilibrium reserve demand

1. Regulatory reforms

a. LCR reform: Allow banks to include financing capacity from non-HQLA loans pledged at the discount window into HQLA, with an upper limit. Estimated impact on reserve demand: $50 billion to $450 billion. Caution: solely changing LCR may cause NSFR to become the new binding constraint, requiring coordinated consideration.

b. ILST and RLEN: If regulators recognize the discount window capacity and short-term liquidity sources, ILST reform could reduce reserve demand by $50 billion to $200 billion; extending RLEN’s time window could reduce demand by up to $100 billion.

2. Supervisory calibration

Adjusting supervisory standards so that banks holding excess reserves to meet examiners’ preferences (e.g., treating T-bills and reserves as “non-equivalent”) could reduce reserve demand by $25 billion to $50 billion. This is a reform achievable through supervisory culture change without legislative changes, but still challenging.

3. Lowering reserve holding yields

Allow the effective federal funds rate (EFFR) to exceed IORB, breaking the current regime where EFFR is below IORB. Using Lopez-Salido and Vissing-Jorgensen (2025) framework, a difference of +2bp (close to September 2019 stress levels) could reduce reserve demand by $150 billion to $550 billion.

However, this path has costs: increased volatility in overnight and repo rates, and potential market preemptive hoarding that could offset demand reduction. Supporting mechanisms like SRP and temporary open market operations (TOMO) would be necessary.

4. Enhancing attractiveness of alternative assets

Upgrading Fedwire, improving Treasury market liquidity, promoting central clearing, etc., aim to make alternative assets more attractive to banks, closer to reserves. These measures also help the private sector absorb securities released during balance sheet reduction.

5. De-stigmatizing Fed liquidity tools

Removing concerns about using discount window, standing repo, and intraday overdraft facilities to lower preemptive reserve needs. This requires systemic transparency, pricing, and communication improvements.

Second group: Directly reducing non-reserve liabilities

1. TGA management recalibration

Reducing the Treasury’s cash buffer in the Fed account from about 5 days’ operations to about 2 days, with excess transferred back to commercial banks (similar to historical TT&L arrangements). Estimated impact: $200 billion to $400 billion reduction in the balance sheet. Recognizes that some of these funds will re-enter banks as deposits, partially offsetting the net effect.

2. Lowering attractiveness of foreign reverse repo pools

Reducing interest payments and setting limits to encourage foreign central banks and sovereign funds to shift funds from reverse repos to U.S. Treasuries. Estimated impact: $0 to $100 billion, effect limited and dependent on external cooperation.

Waugh’s signal: From technical paper to policy expectations

Understanding this paper requires considering the Fed’s personnel background. Market consensus expects Waugh to become Fed Chair. Waugh has long criticized QE and the Fed’s balance sheet expansion, favoring balance sheet reduction.

The jointly released working paper by Milam is seen as a forward-looking signal of the Fed’s policy orientation in the “Waugh era.” The Citic Securities research team notes that, given Waugh’s stance and the potential space revealed by this paper, there is a real possibility of gradual exploration to restart balance sheet reduction under his leadership.

However, both the paper and speech repeatedly emphasize that speed and rhythm are the most critical constraints at the implementation level. Milam explicitly states: “Once reform preparations begin, under the usual pace of government rulemaking under the Administrative Procedure Act (APA), it could take over a year, or even several years.” He cites the SLR reform—taking nearly six years from temporary easing to formal regulation—as an example.

This means the Fed is unlikely to immediately restart balance sheet reduction just because of this paper. The more probable path is to start with less controversial, technically feasible options, while providing markets with forward guidance on how new mechanisms might operate.

Citic’s assessment: Which are feasible, which are more idealistic

From a practical perspective, Citic Securities systematically evaluates the 15 options and concludes:

Feasible options:

• Relaxation of LCR standards: a technical regulatory reform with controllable variables, giving the Fed significant reform initiative;
• Reform of Standing Repo Facility (SRP): straightforward de-stigmatization, no legislative changes needed;
• Upgrading Fedwire and payment systems: infrastructure improvements with clear direction;
• ILST supervisory calibration: some reforms can be achieved through supervisory culture change without legal amendments.

More aggressive or requiring external cooperation:

• Layered reserve interest payments: could trigger nonlinear responses in banks, complex to operate;
• TGA management reform: involves coordination with the Treasury and political consensus;
• Foreign reverse repo pool reduction: highly dependent on external institutions’ willingness, effect uncertain.

Overall, Citic Securities considers this a “reference reform menu that is relatively pragmatic,” but expects actual implementation to lag well behind the potential upper bounds depicted in the paper. It should be viewed as a directional guide rather than an immediate policy commitment.

Market impact: Increased volatility, but no change in rate cut logic

Regarding bonds, the essence of balance sheet reduction is to reduce base money supply, which necessarily increases the scale of private sector holdings of U.S. Treasuries. Citic Securities believes this will amplify market volatility and raise tail risks—though some regulatory easing (like SLR relief) could expand dealer capacity.

In terms of pace, the paper opposes accelerating shrinkage through outright sales; instead, it favors letting maturing securities roll off naturally and providing dealers and repo markets with higher capacity buffers. This objectively limits short-term shocks.

Citic Securities judges that U.S. Treasuries are currently more suitable for trading opportunities, with short-term bonds outperforming long-term ones.

For equities, balance sheet reduction exerts contractionary effects via monetary supply and portfolio rebalancing, but these can be offset by lowering the federal funds rate. They believe that if reforms proceed, the rate path will adjust accordingly, but this is not directly tied to current monetary policy pace. U.S. stocks may wait for a correction window to seek higher safety margins.

For gold, reform is unlikely to fundamentally alter the global central bank’s strategy of increasing gold holdings, which is driven more by geopolitical reshuffling and dollar reserve diversification. Gold remains a medium- to long-term allocation asset.

Milam explicitly states that the contractionary effects of balance sheet reduction can be offset by rate cuts, and “balance sheet reduction may even enlarge the potential decline in the federal funds rate relative to baseline scenarios.” Citic Securities expects U.S. CPI year-over-year to fluctuate between 3.0% and 3.5% within the year, maintaining their view of a 25bp rate cut in the second half of 2026. The reform of the balance sheet is not directly linked to rate cut decisions.