The Federal Reserve’s balance sheet has shrunk from a peak of $8.97 trillion in April 2022 to $6.56 trillion as the central bank has unwound much of the Treasury and agency mortgage-backed security purchases undertaken to support the economy through the global pandemic. This has bought the demand and supply of reserves into much closer balance.
Some advocate shrinking the balance sheet further, for reasons ranging from reducing the Fed’s footprint in financial markets to allowing greater volatility in money market rates in order to better monitor incipient stresses in financial markets and enabling more rate cuts. These advocates miss two important points. First, reducing the balance sheet further would not be an easy task operationally. It would require a dramatic change in how the Fed conducts monetary policy. Second, because a smaller balance sheet would not exert much restraint, it would not open the door for much lower short-term rates.