iFlow > Short Thoughts
Published on Tuesdays, Short Thoughts offers perspectives on US funding markets, short-term Treasuries, bank reserves and deposits, and the Federal Reserve's policy and facilities.
John Velis
Time to Read: 4 minutes
EXHIBIT #1: PRE-GFC, RATE CONTROL WAS ACHIEVED BY OPEN MARKET OPERATIONS
Source: BNY Markets, Bloomberg, Federal Reserve Board of Governors
EXHIBIT #2: SOMA PORTFOLIO IS SMALLER (BY PERCENTAGE) THAN IT WAS PRE-GFC
Source: BNY Markets, U.S. Treasury Department, Federal Reserve Board of Governors, Federal Reserve Bank of New York
Last week, we discussed high-level considerations around the prospect of Kevin Warsh’s return to the Federal Reserve and the possibility he could ultimately assume the role of chair of the Federal Reserve System. Much is expected to change in a Warsh Fed, from his confirmation prospects and views on Fed-Treasury relations to the balance sheet and the Fed’s research agenda, but at this point there are as many unknowns as there are knowns about his imprint on the Fed.
One common thread in our remarks, particularly on rates and balance sheet policy, is the need for Warsh to bring the rest of the FOMC alongside his views on these and other policy levers. At full strength, the FOMC is made up of 12 voters, including the seven Governors, the Federal Reserve Bank of New York president and four other (rotating) regional Reserve Bank chiefs. There is a range of views on rates and the balance sheet, and policy actions are decided by majority vote.
At the January FOMC, when rates were left unchanged, Governors Waller and Miran dissented in favor of a 25bp rate cut. In recent months, unanimity on the committee has been elusive; there have been dissents at every FOMC meeting since July 30, 2025, for five straight meetings with nonunanimous rate decisions.
Our rate outlook for the rest of this year is more dovish than consensus: We see three cuts compared with two priced by the market, based on our expectation of a deteriorating labor market. Note that our outlook does not reflect a view on the new chair’s dovish or hawkish orientation, but rather our expectations for where the macroeconomy is heading. We believe economics, rather than the sensibilities of the new chair, will dictate rate policy. If and when the macro data reach that point, we don’t think the committee will hesitate to loosen policy in response.
The balance sheet, which is too big in Warsh’s view, is another matter. Committee support will also be needed to reduce its size. Building such support will be up to the chair. At present, the balance sheet is growing because of reserve management purchases (RMPs) aimed at keeping funding market volatility under control. Any move to reduce the balance sheet’s size would entail an overt reversal of current committee consensus.
The committee decided in December to initiate RMPs, growing the balance sheet to address the fact that bank reserves were no longer abundant, but merely ample. With reserves in an ample state, more frequent interventions in the open market are required to maintain rate control and stable funding spreads. Changing balance sheet policy would require committee consensus and could create instability in money markets if not offset by the Fed’s open market interventions.
The issue is that open market operations have started with reserves only ample. Even if the committee could be brought around to reducing the balance sheet’s size, more market interventions would be required. With a smaller balance sheet, reserves would test the frontier between ample and scarce. At the beginning of Warsh’s tenure as a Fed governor, before the GFC, reserves were scarce and the effective federal funds rate (EFFR) showed volatility around the federal funds target (Exhibit #1). As the balance sheet grew, reserves became sufficiently ample and thereafter moved to abundant, obviating the need for frequent post-GFC open market operations.
It is not clear that the size of the balance sheet, per se, is the Fed’s most pressing policy issue. As Exhibit #2 shows, Treasury holdings in the New York Fed’s System Open Market Account (SOMA) portfolio as a percentage of public debt outstanding are actually lower than before QE, from about 15% on the eve of 2008 to around 13% currently. Reducing the balance sheet from here would first require an end to RMPs, again a committee-driven decision, and could create stress in funding markets. The line between ample and scarce reserves, much like that between abundant and ample, is impossible to define a priori and could be crossed unintentionally.
We have argued that while the U.S. futures curve is pricing in two rate cuts between now and year end, further weakening in the jobs market over the coming months suggests an additional cut beyond the two currently expected. Labor data last week were poor, and with the January NFPs scheduled for Wednesday, we could receive more data that further cloud the employment outlook.
With the announcement of the Warsh nomination and the weaker jobs data last week, the forward curve has moved only marginally lower. Over a week ago, the market saw rates about 47bp lower at year end, while today it is pricing closer to 57bp. There has been modest movement.
Inflation, which the Fed appeared sanguine about at its last FOMC meeting, remains sticky, and Friday’s CPI will shed further light on the outlook. If the Fed opts for dovish policy this year due to labor data, inflation could remain above its 2% target, and the curve could steepen on the back end.
