This also happens to be a live recording of the Hoover Institution's Capitalism and Freedom in the 21st Century podcast, the official podcast of the Hoover Institution Economic Policy Working Group, where we talk about economics, markets, and public policy. I'm Don Harrell, your host, and today my guest is Stephen Miran, a current governor of the Federal Reserve Board. He's just written this very excellent and very interesting paper titled 'A User's Guide to Reducing the Federal Reserve's Balance Sheet.' And Stephen just outlined his speech, some of the key highlights there, but I really want to spend this conversation really digging in and asking Stephen some questions about this.
The Fed's balance sheet is something that grew to be about $9 trillion in the aftermath of COVID. We entered this phase of abundant reserves, or no longer having scarce reserves, following the global financial crisis. The Fed's now tightening its balance sheet to around $6.7 trillion. In your paper, you've outlined a number of items that would essentially allow the Fed to reduce the balance sheet further. First off, where do you think—I want to sort of get some numbers because you've got some great numbers in your paper—what do you think that sort of terminal size of the balance sheet, or how low can the Fed go right now in absence of some of the changes that you've spoken about, whether it's some regulatory changes around, you know, some Dodd-Frank provisions around holding Treasury securities at banks or de-signitizing the discount window? Where do you think that floor is right now for the Fed balance sheet, and if the Fed were to make, or if there were to be various policy changes that you've outlined made, how low could the Fed then potentially go in your mind?
So, thank you. Look, we are expanding the balance sheet now, and I voted to resume reserve management purchases in December. I supported that policy. And that's because conditional upon the current institutional framework, the regulatory framework, the implementation framework, we had run into an area approaching scarce reserves in December. And so if we were going to maintain an ample reserves framework, we needed to start reserve management purchases and increasing the quantity of reserves in the system and increasing the balance sheet. Now, what I tried to do in the paper and in the speech is to provide a set of options for reducing reserve demand so that we don't have to keep increasing our balance sheet like this. We can go back to shrinking our balance sheet, which to me is the right approach. Now, once we undertake those options, those steps, I see 1 to 2 trillion dollars of potential reserve reduction while retaining ample reserves, which sounds like a good range to me in terms of thinking of reduction, but that's the type of thing that would have to be weighed by the committee in the future in terms of what they wanted to do and how far they wanted to go.
Okay, well, speaking of the committee in the future, the Fed chair nominee Kevin Warsh has spoken in the past quite frequently about how the Fed could potentially move back to a scarce reserve system. When he was a Fed governor, he was at the Fed when the Fed transitioned from being scarce to ample. In your paper and in your speech, you say that you lean toward still being more ample than scarce, but I'm curious, how strong is that lean on scarce versus ample?
So, as I said in the speech, it's a weak lean, and it's certainly not a hill I would die on. It's not even a hill I would take my old wounds on, I don't think. Part of the reason for that—there's two reasons for that lean. One is that we have ample reserves now, and if we have a path to remaining in ample reserves but reducing the balance sheet by up to $2 trillion, it seems if something's working reasonably well but you can reduce the balance sheet, then it doesn't necessitate an institutional change back to scarce reserves. It seems like less work, and so that seems like a positive to me. The other reason is that we still do live in a world with Dodd-Frank and Basel, and I do think that you could have scarce function in a world of Dodd-Frank and Basel, but there's some more questions in my mind. So, it's a weak lean, and I could be talked into scarce, but that's sort of my thinking at the moment, and because we're sort of still studying the subject, I could imagine my thinking on it evolving as we continue to do more research.
Got it. So, scarce reserves hypothetically possible, but obviously would need, you know, Congress to act sort of outside the purview of the Fed to get there. I want to talk a little bit about the paper, and in particular, you know, you outline a number of items on the liability side of the balance sheet that could minimize distortions around shrinking the balance sheet. These are things, you know, related to sort of proper functioning of repo markets and things like we mentioned before, some of the discount window and so forth. But what about the asset side? There's also this sort of risk as well of, you know, potentially, you know, as the Fed's winding down the asset side of the balance sheet, selling Treasury securities, if it did this too quickly, maybe it could enter sort of a taper tantrum 2.0 situation. This was an event that happened 10 years ago when, you know, essentially some comments from then Fed chair Ben Bernanke caused the term premium or the difference between long-term government bond yields and short-term government bond yields to really jump pretty dramatically. What are the things that you think would be helpful there if the Fed were to really continue on a very serious path of trying to reduce the balance sheet? What sorts of things could produce those frictions on the asset side?
Sure. So I like that framing of it. Let me just repeat it a little bit so that it'll make my answer make a little bit more sense. So when we reduce our balance sheet, you know, a balance sheet has assets and liabilities, and if you reduce the balance sheet, you're reducing both assets and liabilities. Now, the bulk of the paper deals with the liability side of it, which is reserves. You know, banks own reserves, those are assets on the bank side, liabilities on the Fed side. And when we reduce reserves, you know, in the past, we get to a point where there starts to be a little bit of mayhem in short-term funding markets, and that tells you that you're approaching scarce reserves, and you need to stop. And like the 2019 repo crisis.
Yeah, or late 2025, there were some, you know, higher repo rates, right? And most of the options in the paper deal with reducing reserve demand to allow you to reduce the balance sheet further before you get to that.
And those are—I listed a number of those in the speech as well without going into details because it's a 50-page paper. On the asset side, the Fed owns securities, Treasuries and MBS, and you're referring to the taper tantrum that happened in 2013, you know, big increase in long-term interest rates. And you know, on the liability side, we talked about sort of making sure that repo markets don't go haywire when you're reducing the balance sheet, but you also have to think about the asset side, too, and how do you avoid a spike in long-term interest rates that you don't necessarily want as a result of what you're doing. And so I mentioned going slowly, I think that's important. But I think another thing that you—there's a couple other steps that you can do that we mentioned in our paper, and they have to do with some regulatory implementation things. And so one of them is going to central clearing of Treasury repo. Because if you own a Treasury on repo, you've got a risk charge not for the Treasury on the risk-weighted side of the regulatory regime, but for the repo exposure, for the counterparty exposure in repo. And if you can novate across trading partners, you've got a long position with this guy and a short position with that guy, they'll net out, and then you won't have the charge. And so you reduce the regulatory burden of owning Treasuries on repo. That's one thing that you could do that we discussed in the paper. Another is the G-SIB surcharge on the risk-based side as well. And so Treasury securities in the risk-based side of the regulatory framework are supposed to have a zero capital weight because they're Treasuries, but they don't actually have a zero capital weight in calculating the G-SIB surcharge because they make banks more systemically important if you own more Treasuries. And so there's a little bit of a distortion to the way that we think about zero risk weight in the risk-based side for Treasuries. And so those are some reforms that you could take on the regulatory side that would make it a little bit easier for markets to absorb securities that are coming off of our balance sheet.
Mhm. I know economists like Carol Duffey and others have talked about, you know, essentially clearing Treasuries as well. A lot of very interesting ideas in this paper. I think it's a very bold, very bold paper that we rarely see from Federal Reserve governors. So I commend you for making a bold stand, answering a very telling, a very difficult and very important question for the Fed. I want to talk a little bit about inflation. We're still above 2% inflation. We are now—we have a war and engagement in Iran. The Strait of Hormuz still appears to be closed. Oil prices have been volatile. What do you see underlying inflation over the next 12 to say 24 months, and does Iran in any way sort of change some of your, I guess, prior comments on how easy monetary policy should be, or should this maybe be used as sort of a one-time shock that passes through and sort of ignored by policymakers, just a supply shock? I didn't think about these sort of recent developments.
Sure. So, I still see underlying inflation as gradually moving down towards target over the next, you know, sort of 12 months, let's say. I think underlying inflation is remaining very well-behaved and with the labor market on a very, very gradually loosening trend for 3 years now, it's very difficult for me to imagine that changing. Now, the oil shock, of course, is very real. But, the way that oil shocks work when you think about inflation is they boost the price level pretty quickly. You know, gas prices move up pretty quickly, right? Or airline fares move up pretty quickly. Anything that's really tied to oil in a very powerful way tends to move up very quickly. But, monetary policy hits the economy with lags, with long and variable lags. And most people think that those are 12 to 18 months. And so, what happens with the oil price is it lifts the price level pretty immediately because it feeds through into gas prices and other stuff immediately. But, then unless there are second-round effects, then you don't have inflation as a result of oil 12 to 18 months out. Inflation 12 to 18 months out is pretty much unaffected. And you see this in inflation expectations. So, I like to look at the CPI swap market. And 1-year swaps, you know, moved up a lot. But, as you look at forward rates, if you look at the 1-year rate 1-year forward and the 1-year rate 2-years forward and the 1-year rate 3-years forward, they haven't really moved. If anything, they're actually down since the January FOMC. So, and they haven't really moved much in response to the Iran shock at all. So, if we change interest rates now, it wouldn't hit the economy for 12 to 18 months from now, but the market isn't really seeing any inflation from the oil shock 12 to 18 months from now because it all happens immediately. What you would get is a much weaker economy as a result of tighter monetary policy. And so, this is why classically central banks look through oil shocks. And I tend to think that the traditional wisdom on—I mean, I'm very, as you can tell from the speech and other things that I've said and written in the last several years, I'm very happy to challenge conventional wisdom when I think it's wrong. But, in this case, I think conventional wisdom's right.
Terrific. I want to shift to unemployment. Unemployment's sort of been in between sort of 3 and a 5% handle in the past few years. It sort of inched up little by little. It's still very low compared to the long-run, you know, post-war time series. How tight is the labor market right now in your mind? How close are we to what you might call full employment?
So, the labor market, you know, was extremely tight in 2021-22. And then as the Federal Reserve started its tightening cycle, the labor market set into a very gradual cooling trend. That trend's been in place for 3 years. I think given labor markets tend to show a lot of momentum, they tend to show a lot of persistence in underlying trend. And if this trend has been going on for 3 years, it seems to me that it should be the null hypothesis when you're thinking about how the labor market has changed. I haven't seen anything that's convinced me that this 3-year-long trend has adjusted. There are some folks who think the labor market is showing signs of stabilization. I think the trend has continued and therefore merits additional support for monetary policy. Monetary policy is modestly restrictive, and I don't think that the labor market really calls for that.
