Warsh’s Balance Sheet Views Make Rate Cuts A ‘Need’ Not A ‘Want’

Two Parts To The Policy Mix

Everyone understands the macroeconomic impact of shifts in the fed funds rate. Higher rates, typically lead to slower inflation, but higher unemployment & slower growth. Lower rates, the opposite.

But, the FFR is not the Fed’s sole monetary tool, nor is it the sole determinant of the overall policy stance.

The balance sheet, of course, is the other element of the policy mix, and in many ways is a much more important one, particularly given the ‘ample reserves’ regime through which policy is now transmitted.

Two things determine the degree of restriction, or otherwise, that the balance sheet exerts - its overall size, and the duration of its holdings (ie, the weighted average maturity, or WAM). In simple terms, the larger the balance sheet, the greater the easing effect that it has, and vice versa. Similarly, the longer the WAM of the portfolio, the greater the loosening effect it has, and vice versa.

Quantifying all of this is difficult, but in many ways the precise relationship equating shifts in the balance sheet to shifts in the FFR is less important than the direction of travel. Here, I’m going to use the following rules of thumb; +/-$1tln in the balance sheet size ≈ +/-75bp in the FFR, and +/-2yrs in the balance sheet WAM ≈ +/-25bp in the FFR. You can, and I’m sure folk will, plug their own assumptions into that equation.

Tidying Up The Balance Sheet

Whatever, Fed Chair nominee Warsh has been clear in his desire to not only have a smaller balance sheet, but to have a tidier one as well, expressing a dislike of the balance sheet holding long-term assets. This suggests, then, that Warsh will try to both shrink the overall size of the balance sheet, and probably carry out a sort of reverse ‘Operation Twist’ in order to sell-down some of those long-term assets in the portfolio.

Now, doing this, without causing issues so far as financial plumbing is concerned, will require changes to banking regulation, and a smoother way of shifting reserves to where they are needed in the system. Neither of these, though, are insurmountable issues.

Assuming that Warsh does indeed shrink the balance sheet, and shorten the portfolio’s duration, if the Fed funds rate were held steady, this would all amount to a net tightening of the overall policy stance!

Smaller Balance Sheet = Lower Fed Funds Rate

At that point, it's not that rate cuts would be a ‘nice to have’, but that a lower fed funds rate would be a necessity in order to maintain the same overall policy stance. Again, assumptions may vary, and the scope of these changes will impact the figures involved too, but one can easily see a world where, having trimmed $1tln from the balance sheet, and shortened the duration by a couple of years, then room to lower the FFR by somewhere between 100-150bp opens up.

In other words, from the overall policy perspective, a 3.75% FFR/$7tln balance sheet/8yr WAM (aka the current regime) represents the same stance as a 2.50% FFR/$6tln balance sheet/6yr WAM regime.

Still A Risk-Positive Mix, If The FOMC Can Be Convinced

For markets, the implications are clear. Maintaining the same overall stance means this shouldn't be a hurdle for risk assets and, if anything, the lower FFR may act as a tailwind in isolation, especially for growth stocks, as future cash flows are discounted less aggressively. In the Treasury complex, meanwhile, a steeper curve is the obvious consequence, while medium-term SOFR futures expiring in 12-18 months (reds), should rally.

While the maths here adds up, and to me the logic is clear, perhaps Warsh’s biggest issue will be convincing his colleagues on the FOMC to buy into this stance. His powers of persuasion are about to be given a workout!