Powell advances the reform of the Federal Reserve's balance sheet. Wall Street warns that shrinking the balance sheet may disrupt the financing market.

Federal Reserve Chairman Kevin Wash recently formed a special working group to conduct a comprehensive assessment of the Federal Reserve's balance sheet, which totals $6.7 trillion. Wall Street analysts believe that the biggest challenge the working group will face is how to reduce the size of the balance sheet without disrupting the financing market. Wash announced the formation of five special working groups last week to evaluate the Federal Reserve's frameworks in various areas such as monetary policy, inflation, and policy communication, which may lead to a series of major reforms. Among them, the working group responsible for assessing the balance sheet is believed by the market to have the most profound impact on the financial markets. Ed Al-Hussainy, a fund manager at Columbia Threadneedle, stated that the balance sheet has always been an area of focus for Wash and is the most likely direction for reforms to have a substantive impact on the market. The working group is co-led by former Federal Reserve Governor and Harvard University economics professor Jeremy Stein, former Governor of the Reserve Bank of India and professor at the University of Chicago Booth School of Business Raghuram Rajan, and Harvard University economics professor Karen Dynan. Their main task is to study how to reduce the Federal Reserve's influence in the financial markets, as Wash has long advocated reducing the Fed's direct intervention in the market. However, Wall Street analysts believe that the working group not only needs to study how to reduce the balance sheet, but also must answer a more important question: how should the Federal Reserve respond in the event of another liquidity crisis in the future? Analysts point out that in September 2019, US repo market rates soared to nearly 10%, forcing the Fed to urgently inject about $500 billion in liquidity into the market; in the early stages of the COVID-19 pandemic in 2020, the US Treasury market also plunged into chaos due to a "cash grab," prompting the Fed to launch massive asset purchase programs to stabilize the market. Last year, the Fed also ended its balance sheet reduction early and instead injected reserves back into the financial system by purchasing short-term US Treasuries when signs of pressure in the financing markets emerged. Joseph Abate, head of US interest rate strategy at SMBC Nikko Securities America, said that the experience of the past few years shows that the Fed has almost "zero tolerance" for a significant rise in repo market rates, so the actual room for balance sheet reduction in the future is quite limited. Market participants believe that the size of the balance sheet not only relates to how many US Treasuries the Fed holds, but also directly affects the liquidity of the US money market and the stable operation of the Treasury market. If the balance sheet reduction is too aggressive, bank reserves may plummet rapidly, leading to higher financing costs, increased volatility in the US Treasury market, and even forced unwinding of positions by some institutions that rely on financing transactions, causing chain reactions in the global bond market. Brij Khurana, a fund manager at Wellington Management, stated that the working group members are all seasoned economists with extensive policy-making experience and can formulate reform plans with the help of the Federal Reserve research team. However, he also warned that reducing the balance sheet could affect the US dollar's direction, long-term US Treasury yields, and overall market volatility. He pointed out that many hedge funds still participate in the US Treasury market through strategies such as "basis trading," and these trades to some extent depend on the Fed providing ample liquidity. If the balance sheet continues to shrink, future volatility in the US Treasury market may further intensify. At the same time, some analysts are concerned that the working group members mainly come from academia and policy research fields, lacking frontline experience in banks and financial markets. The proposals they put forward may have strong theoretical value but face significant challenges in practical implementation. Abate stated that there are almost no experts from commercial banks or financial markets in the working group, so the recommendations regarding raising repo rates or reducing Treasury purchases may not have enough practical reference value for the market impact they may bring. Lou Crandall, chief economist at Wrightson ICAP, is skeptical about returning to a "small balance sheet era." He believes that during periods of scarce reserves, implementing monetary policy by the Federal Reserve is more costly and is more likely to trigger market liquidity risks. Therefore, maintaining an appropriately sized balance sheet may better meet the current financial market operating needs.