Fed: Emphasis on balance sheet and trajectory of rate reductions – BNY

Fed’s Evolving Balance Sheet Approach and Outlook for Rate Changes

John Velis, Americas Macro Strategist at BNY, examines the increasing focus on the Federal Reserve's balance sheet reduction. Influential figures such as Kevin Warsh and Stephen Miran advocate for a leaner balance sheet, primarily achieved by lowering reserve levels. BNY’s broader macro perspective anticipates the Fed will begin reducing interest rates in the second half of 2026, provided that tensions in the Middle East subside, input costs decrease, and the US labor market shows signs of softening.

Shifting Priorities in Fed Policy

The Federal Reserve’s balance sheet is becoming an increasingly prominent subject, expected to attract even more attention in the near future. BNY has regularly analyzed both the intricacies of balance sheet management and the importance of reserve levels, noting their close relationship—reserves represent the largest liability on the Fed’s books, surpassing even currency circulation.

Several Fed leaders, including Kevin Warsh, who is nominated for Fed chair, have expressed intentions to shrink the balance sheet over the coming years. The main strategy involves reducing the volume of reserves circulating within the financial system.

Exploring the Balance Sheet “Trilemma”

The Fed’s so-called balance sheet “trilemma” suggests that downsizing the balance sheet is only possible if the central bank accepts heightened money market volatility or frequently intervenes in open market operations to stabilize rates. However, Perli (SOMA manager at the NY Fed) and Miran propose an alternative: decreasing banks’ structural need for reserves, which could enable a smaller balance sheet without triggering rate instability.

BNY’s Forecast for Rate Cuts

BNY continues to predict that the Fed will lower interest rates in the latter half of 2026, despite ongoing skepticism in the markets. Recent activity suggests that rate markets may be starting to reconsider their stance.

To clarify, if the conflict in the Middle East diminishes by midyear and energy along with other essential input prices ease, BNY sees a viable route for rate reductions. The forecast does not depend on prices returning to levels seen before the conflict, nor is this a requirement for their projection.

(This article was produced with assistance from an AI tool and subsequently reviewed by an editor.)