Brookings Institution researcher Robin Brooks published analysis on Substack on the 5th (local time) arguing that the Federal Reserve cannot meaningfully reduce its balance sheet without accepting higher long-term Treasury rates, casting doubt on potential Fed Chair Kevin Warsh's stated commitment to balance sheet reduction. Brooks stated there is no way for the Fed to shrink its balance sheet without rising long-term Treasury rates, diagnosing that the likelihood of meaningful reduction is slim. The Fed began rapidly expanding its balance sheet after the 2008 financial crisis through massive purchases of Treasury securities and mortgage-backed securities, a form of quantitative easing (QE) deployed after conventional rate-cutting tools were exhausted at zero.
Brooks Argues Balance Sheet Reduction Requires Higher Treasury Rates
Brooks explained that if the Fed must now reduce its balance sheet, it means accepting higher interest rates on Treasury securities. He stated that fiscal policy is clearly out of control and needs a reality check, adding that he personally thinks rising Treasury rates would be a good thing in this context. The Fed's asset purchases were recognized as a particularly powerful form of forward guidance for monetary policy because they involved actual deployment of capital into markets.
Brooks assessed that the probability of such rate acceptance is very low. He noted that the balance sheet stands at 21% of GDP, with Treasury securities comprising two-thirds of holdings, making it virtually impossible for the Fed to dispose of a significant portion of these Treasuries.
Fed Balance Sheet Stands at 21% of GDP with Structural Reduction Obstacles
Brooks analyzed that quantitative tightening (QT) has always been smaller in scale and shorter in duration than QE because the system cannot handle the interest rate increases and resulting volatility that more aggressive balance sheet reduction would entail. He stated that while the Fed is adept at buying, it is not skilled at selling, predicting this critical flaw will be a factor for balance sheet expansion rather than reduction in the medium term.
Brooks pointed out that bad shocks like COVID-19 occur periodically in financial markets. He emphasized that because private demand for the massive debt issuance resulting from such shocks is low, the Fed purchases Treasuries to prevent interest rate spikes, with the problem being that this debt accumulation is permanent.
Alternative Mechanisms Have Limited Capacity to Enable Reduction
Commercial banks could hold more Treasury securities allowing the Fed to reduce its balance sheet, but this approach is identified as a measure carried out under the name of financial repression. The Fed could also issue more short-term Treasuries to prevent the rise in Treasury rates resulting from balance sheet reduction.
Brooks diagnosed that while these methods have been increasingly used in recent years, the scope for these tools to offset meaningful Fed balance sheet reduction is very limited. He stated that meaningful balance sheet reduction would be a good thing because it would strengthen the market's role in determining interest rates, making policymakers more aware of reckless fiscal policy that is out of control.
Brooks predicted that unfortunately, for precisely that reason, meaningful balance sheet reduction will not happen. He criticized that the common thread across successive U.S. administrations is adherence to irresponsible fiscal policy and refusal to face reality.
FAQ
What did Robin Brooks say about Fed balance sheet reduction on the 5th?
Robin Brooks published analysis on Substack on the 5th (local time) arguing that the Fed cannot meaningfully reduce its balance sheet without accepting higher long-term Treasury rates, stating the likelihood of meaningful reduction is slim.
Why does Brooks think Fed balance sheet reduction is unlikely?
Brooks explained that the Fed balance sheet stands at 21% of GDP with two-thirds in Treasury securities, making significant disposal virtually impossible. He stated that QT has always been smaller and shorter than QE because the system cannot handle the rate increases and volatility that aggressive reduction would cause, and that periodic shocks require the Fed to purchase Treasuries to prevent rate spikes, making debt accumulation permanent.
