Recently, an analysis from Wall Street Insights made me think that the Fed's balance sheet reduction topic might need to be fundamentally rewritten.

The core idea is this: for a long time, everyone believed that the Fed's balance sheet reduction had a ceiling—once reserves are exhausted, they have to stop. But Milan and his team recently published working papers that challenge this understanding. They point out that the demand for reserves can itself be shaped by policy. In other words, by adjusting the regulatory framework, the Fed could significantly shrink its balance sheet while still maintaining "adequate reserves." This approach is indeed intriguing.

Wells is about to become the Fed Chair, and he has long been dissatisfied with the balance sheet expansion policy since QE. This paper, to some extent, is paving the way for his future policy direction. The market generally expects that under Wells' leadership, the Fed will reconsider balance sheet reduction, but the key is how to control the speed and pace.

The paper provides specific figures. Based on Fed data from March this year, reserve demand could decrease by $825 billion to $1.75 trillion, corresponding to a reduction of the entire balance sheet by $1.15 trillion to $2.125 trillion. This would bring the balance sheet from roughly 21% of GDP today back to levels seen in 2012 or 2019. The paper explicitly states that returning to pre-crisis levels below 10% is "impractical and unnecessary."

How to reduce? The paper lists 15 options, but not simply additive. The more feasible ones, in my view, include relaxing LCR standards, reforming standing repo facilities, and upgrading payment systems. Some options, like tiered reserve interest payments or adjusting TGA management, involve complex coordination and would progress much more slowly. CITIC Securities' assessment aligns with this—while the menu is practical, actual implementation will lag far behind the theoretical potential.

From a market impact perspective, balance sheet reduction essentially reduces the supply of base money, which will inevitably increase the scale of U.S. Treasuries that the private sector needs to absorb. This could amplify volatility and increase tail risks. Interestingly, both the paper and speeches emphasize that rate cuts can offset the contraction effects of balance sheet reduction. Milan explicitly states that "balance sheet reduction could lead to a larger decline in the federal funds rate relative to baseline scenarios."

Therefore, the current logic is: if balance sheet reform advances, the interest rate path will adjust accordingly. CITIC predicts that U.S. CPI could fluctuate between 3.0% and 3.5% this year, maintaining their view of a 25 basis point rate cut in the second half of the year. The balance sheet reform and rate cut decisions are not directly linked.

Implications for different assets: U.S. Treasuries currently offer trading opportunities; short-term bonds may outperform long-term bonds; U.S. stocks can wait for pullbacks to find better safety margins; gold still holds medium- to long-term value, as the logic of global central banks increasing gold holdings mainly stems from geopolitical risks and the trend of dollar reserve diversification—balance sheet reduction won't change this big picture.

Interestingly, the paper also points out an overlooked issue: banks hoard reserves not only because of regulatory requirements but also because reserve interest rates are higher than short-term government bonds, the discount window has long been stigmatized, and a "ratchet effect" formed by multiple liquidity indicators. These issues can be improved through policy adjustments.

Overall, this paper represents a new way of thinking—moving from passively waiting for reserve scarcity to actively adjusting demand-side mechanisms. But reforms take time; the Fed's administrative procedures might take over a year or even several years. So, in the short term, the Fed is unlikely to immediately restart balance sheet reduction because of this paper. Instead, it will probably start with less controversial, technically feasible options, while providing forward guidance to the market.