A significant research paper from the Federal Reserve, led by Governor Stephen Milan alongside three economists, challenges conventional market wisdom regarding the reduction of the central bank's balance sheet, commonly known as quantitative tightening (QT). The paper argues that the primary constraint is not a shortage of reserve supply but rather an artificially elevated baseline for reserve demand, shaped by regulatory rules. It outlines 15 potential policy reforms that could allow the Fed to shrink its balance sheet by up to $2.1 trillion. Analysis from CITIC Securities suggests that while some options are feasible, the implementation timeline will likely be much slower than the paper's potential suggests, and the firm maintains its forecast for a 25-basis-point Fed rate cut in the second half of the year.
The core insight of the paper lies in shifting the perspective from supply-side limitations to demand-side drivers. It posits that reserve demand is not a fixed, exogenous constraint determined purely by payment settlement needs. Instead, it is significantly elevated by a combination of regulatory frameworks, supervisory practices, and the Fed's own operational setup—a phenomenon the paper terms "regulatory dominance" over the Fed's balance sheet.
Governor Milan presented multiple rationales for reducing the balance sheet. Key reasons include minimizing market distortions caused by the Fed's oversized footprint, controlling financial risks associated with large-scale asset holdings and resultant remittance volatility to the Treasury, preserving the boundary between monetary and fiscal policy, and retaining policy space for future crises.
The paper identifies three key mechanisms that artificially inflate reserve demand: 1. The interest rate spread makes reserves a attractive "risk-free" asset, especially when the Interest Rate on Reserve Balances (IORB) exceeds short-term Treasury bill yields. 2. A "ratchet effect" created by overlapping liquidity regulations—such as the Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR), and Supplementary Leverage Ratio (SLR)—means that easing one rule often causes another to become the new binding constraint. 3. The persistent "stigma" associated with using the Fed's liquidity facilities, like the discount window and the Standing Repo Facility (SRP), discourages banks from relying on them during stress, leading them to hoard reserves preemptively.
The paper provides quantitative estimates based on the Fed's H.4.1 report data from March 11, 2026, when total assets stood at approximately $6.646 trillion. Using a Monte Carlo simulation framework to account for interactions between policies, it estimates the potential reduction in the balance sheet could range from $1.15 trillion to $2.125 trillion, with a median estimate of around $1.637 trillion. This would bring the balance sheet size relative to GDP closer to levels seen in 2012 or 2019.
The 15 policy options are categorized into two groups. The first group focuses on lowering the equilibrium demand for reserves through measures like reforming the LCR and ILST standards, adjusting supervisory practices, reducing the attractiveness of holding reserves by allowing the Effective Federal Funds Rate (EFFR) to trade above the IORB, enhancing the appeal of alternative assets like Treasuries, and de-stigmatizing the Fed's liquidity tools. The second group targets the direct reduction of non-reserve liabilities, such as recalibrating the Treasury General Account (TGA) balance and reducing the attractiveness of the foreign reverse repo pool.
The release of this paper is viewed in the context of the anticipated leadership of Kevin Warsh as Fed Chair, who has been a longstanding critic of the expanded balance sheet. However, the paper and accompanying speech emphasize that implementation would be a slow process, likely taking years, governed by the standard administrative procedure act timelines.
CITIC Securities assesses the feasibility of the various options. They view reforms to the LCR, SRP, payment systems like Fedwire, and ILST supervision as having realistic near-term potential. In contrast, options such as tiered reserve remuneration, TGA management reform, and reducing the foreign reverse repo pool are considered more complex, requiring significant external coordination or carrying higher operational risks.
Regarding market impact, CITIC Securities believes QT would increase market volatility by requiring the private sector to absorb more Treasury securities. However, a likely slow, natural roll-off approach would temper immediate shocks. For equities, any contractionary effects from balance sheet reduction could be offset by lower policy rates. The strategic rationale for global central banks to accumulate gold is unlikely to be altered by Fed balance sheet policies, as it is driven more by geopolitical factors and reserve diversification. CITIC Securities maintains its expectation for a 25 bps rate cut in the latter half of the year, viewing balance sheet reduction and rate decisions as not directly linked.
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