chairman’s recommendations 100% of the time, which wasn’t unusual, as most proposals were unanimously approved by the Federal Open Market Committee (FOMC), of which each governor is a member. Toward the end of his tenure, his speeches began to voice at least caution in the continued buildup of the balance sheet, indicating concern about overstimulating an economy that was already borrowing at effectively zero interest rates. While by no means being radical, Warsh was considered by most fed-watchers in the “hawk” category. What’s Transpired Since Fast forward a decade to 2021. We had navigated past the GFC, only to face the COVID-19 pandemic. The Fed, now under the chairmanship of Jay Powell, once again cut overnight borrowing costs to near zero and, more pertinently, launched another QE phase that made all previous bond-buying escapades look timid. From March 2020 to August 2022, the Fed added more than $4 trillion in bonds to its balance sheet, for the expressed purpose of lowering the cost of borrowing for all of us. As it continued to buy at ever lower yields, the Fed’s escape route once the pandemic played out was always going to be fraught with peril. Since the balance sheet peaked at nearly $9 trillion in August 2022, the Fed has run off over 25% of its holdings. By “run off,” I mean they’ve let short-term Treasury bonds simply mature, without replacing them. The Fed’s bond collection has had a “barbell” structure: lots of short Treasuries and lots of very long mortgage-backed securities (MBS). As the shortest bonds have gone away, and the very longest bonds are now more highly weighted, the average maturities have correspondingly increased. Also, the MBS portfolio, which is nearly one-third of its holdings, is dominated by very low coupons. Currently, 93% of its MBS have stated interest rates of 3.5% or lower. Work To Do Why this matters: Warsh has written about his expectations to further shrink the balance sheet, even though the organic cash flows have decreased. He has been quoted as saying, “By draining as much as $2.5 trillion in excess reserves, the Fed would mitigate inflation …” So, it seems relevant to investigate how quickly (or slowly) it will take for $2.5 trillion to roll off. Here’s the tall task: The Treasury portfolio will shed about $2 trillion by 2031, and the MBS portfolio, depending on prepayments, will shrink by about $200 billion per year. So, if the Fed simply sits on its current holdings, we’re looking at a multiyear proposition to get the balance sheet to roughly $4 trillion. The alternative is to sell some of its holdings, which can be easily accomplished as the portfolio consists of high-quality, highly liquid bonds. The rub is that interest rates are likely to be under at least temporary pressure to rise, as the supply would need to be digested. That, of course, would be a means of ultimately keeping inflation under wraps, but it’s hard to see how the FOMC could be in a rate-cutting cycle during this wind-down; it would mean the Fed would be injecting and removing stimulus simultaneously. Conundrum indeed. Stay tuned! Chairman Warsh’s fed promises to deliver some headlines in 2026 and beyond. Jim Reber (jreber@icbasecurities.com) is president and CEO of ICBA Securities. 7 In Touch
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