Fed balance sheet review points to constraints on faster bond runoff

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Fed balance sheet review

Highlights

Fed's balance sheet remains around 60 percent above pre-Covid-19 levels, despite more than $2tn of bonds rolling off between 2022 and 2025.
Task force led by Rajan, Stein and Dynan is evaluating whether balance sheet size, asset mix, and structure constrain further reductions due to liquidity implications.
IMF paper finds U.S. tariffs are being passed to buyers, prompting importers to shift toward lower-priced and potentially lower-quality goods without materially reducing the trade deficit.

Task force weighs size and structure

As reported by Financial Times, the three-member group led by Raghuram Rajan, Jeremy Stein and Karen Dynan is examining the costs, benefits and institutional effects of the Fed’s asset holdings. The review centers on whether the central bank’s balance sheet remains too large, whether it holds the right mix of assets and how its structure affects financial stability and bank liquidity.

The balance sheet remains elevated even after more than $2tn of bonds rolled off between 2022 and 2025. The article says its current scale reflects years of quantitative easing that extended beyond emergency conditions, leaving Fed holdings about 60 per cent above pre-Covid-19 levels and seven times larger than before the global financial crisis.

Rajan has argued in papers with NYU’s Viral Acharya that repeated bond buying makes the financial system more dependent on central bank liquidity. In that view, when the Fed later allows assets to mature, reserves fall but deposit and credit obligations remain, creating liquidity pressure that can unsettle money markets and limit how far the balance sheet can shrink.

Stein, a former Fed governor, has made the case that a large balance sheet can support market functioning by replacing fragile private liquidity with safer public assets. More recently, he has argued that the more important issue is not the overall size of Fed holdings but their maturity, especially the amount of long-duration interest rate risk retained after policy conditions normalize.

Tariffs push importers toward cheaper goods

Trump is also escalating trade rhetoric again, including threats of 50 per cent tariffs on Canadian goods, even as the broader economic effects of earlier tariffs remain limited. The piece says the measures have neither caused a broad slowdown nor materially improved manufacturing, while the U.S. trade deficit is little changed from two years ago.

An IMF working paper cited in the article finds that tariffs are leading U.S. importers to trade down rather than forcing foreign exporters to cut prices. Duties are being passed through to buyers, who are shifting within product categories toward lower-priced suppliers, with part of that change reflecting demand for lower-quality varieties.

That substitution helps explain why tariffs have not produced a bigger inflation surge. But it also raises questions for industry about whether lower-quality imported inputs could have wider effects on production standards, supply chains and business investment.

In our earlier article on investors shifting bond allocations toward short-term U.S. Treasuries, we highlighted strong inflows into ultra-short Treasury ETFs as markets stay wary of long-duration risk. We also noted that persistent inflation uncertainty, potential for higher rates, and deficit concerns are keeping pressure on longer-dated yields and making long-term government bonds less attractive as a defensive hedge.

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