Reducing the Fed’s Balance Sheet With Fed Board Governor Stephen Miran

- 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 John Harley, your host, and today my guest is Steve Myron, a a current governor of the Federal Reserve Board. And 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 Steve just outlined his speech, some of the key highlights there, but I really want to spend this conversation really digging in and, and asking Steve some questions about this. So, Fed's balance sheet, something that drew to to be a about $9 trillion in the aftermath of COVID. This we entered a, this phase of abundant reserves are no longer having scarce reserves following the global financial crisis. The feds now tighten its balance sheets around $6.7 trillion. In your, in your, 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, and I want to sort of get some numbers 'cause you've got some great numbers in, in your paper. One, what do you think the sort of internal size of the balance sheet or, 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 DOD van provisions around holding treasury securities, the banks, or destigmatizing 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, 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 area approaching scarce reserves in December. And so if we were going to maintain an ample reserves framework, we needed to start reserve managing purchases and increasing the quantity of reserves in the system and increasing the balance sheet. Now what I've tried to do in, 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 and we can go back to shrinking our balance sheet, which to me is the right, is the right approach. Now, once we undertake those options, those steps, I see one to $2 trillion of potential reserve reduction while retaining ample reserves, which sounds like a, you know, that sounds like a good range to me in, 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 how, what they wanted to do and how far they want it to go.

- Okay. Well, speaking of the committee in the, in the future, the third chair nominee, Kevin Walsh has spoken in the past quite frequently about how the Fed could potentially move back to a, a scarce reserve system when, when he was a Fed governor, he, he was at the Fed when the Fed transitioned from being scarce to, to ample in your paper, in in, sorry, in your speech you say that you lean toward still being more ample than scarce, but I'm, I'm curious how strong is that lean on scarce, for example?

- So as I said in the speech, it's a weak lean and you know, I I I, it's certainly not a, it's very far from a, a hill I would die on. It's not even a hill I would take mild wounds on. I don't think it's part of the reason for that. There's, there's two reasons for that lien. 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 necess necess state 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 you know, I do think that you could have scarce function in a world of Dodd-Frank and Basel, but there's some more questions in, in my mind. So it it's a weak lean and you know, I, I could be talked into, into, into scarce, but that's sort of my, my thinking at the moment. And, and because we're sort of still studying this 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, to get there. I wanna talk a a a little bit about the, the paper in in particular, you, 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 function of repo markets and things like we mentioned before, some of the, you know, 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 feds 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, 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, the term premium or the difference between long term government bond yields and short term government bond yields to, to really jump pretty DMA dramatically. What are the things that you think would be helpful there if, 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, so I like that framing of it. Let me just, let, just repeat it a little bit so that to make my answer make a little bit more sense. So, so when we reduce our balance sheet, you know, the balance sheet is assets and 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, in short-term funding markets. And that tells you that you're approaching scarce reserves and, and you need to stop and a lot, it's like the 2019 repo, right? Yeah. Or late 2025, there were some, you know, higher repo rates, right? And, and most of the options in the paper are deal with reducing reserve demand to allow you to use the, the balance sheet further before you get to that. And those are, I listed a number of those in, in, in the speech as well without going into details because it's a speech and not a 50 page favor 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 in in long, long-term interest rates. And, you know, on the, 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, 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 stuff that you can do that i, that we mentioned in our paper and they have to do with, with, with some regulatory implementation things. And so one of them is improve, one of them is going to central clearing of, of, of treasury repo. Because if you, you know, if you, if you own a treasury on repo, you've got a risk, 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 and repo. And if you can novate across partner, across trading, trading partners, you've got a 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, 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 gsib 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, they're treasuries, but they don't actually have a zero capital weight in calculating the zero in, in calculating the, the gsip surcharge because they make, they make banks more systemically important if you own more treasuries. And so it, so there's a little bit of a distortion to the way that we think about zero risk weight in the, in, in the risk based sign for, for treasuries. And so there's, those are some reforms that you could take on the regulatory side that make it a little bit easier for markets to absorb securities that are coming off of our balance sheet.

- I I know academics like Carol Duffing and others have talked about, you know, centrally clearing treasuries as well. A lot of very interesting ideas in, in this paper. I I think it's a very bold, very bold paper that we rarely see from Federal Reserve governors. So, so I, I I commend you for making a, a bold stand by answering a, a, a very attempting to answer a very difficult and, and very important question for the Fed. I wanna talk a little bit about inflation. We're still above 2% inflation. We are now, we have a, a war and engagement in Iran, the Strader from Rous. So 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 may just be used as sort of a one-time shock that that passes through and, and sort of ignored by policy makers just a supply shock? I didn't think about these sort of recent developments.

- Sure. So I still see underlying inflation as, as, as gradually moving down toward, 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 three years now, it's very difficult for me to imagine to, to imagine that changing. Now the oil shock, of course is, 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, very powerful way tends to move a very quickly, but monetary policy hits the economy with lax, with long and variable lags, and most people think that those are 12 to 18 months. And so what happens with an oil price is it lifts the price level pretty immediately because of the, because it feeds through into gas prices and, 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 the, you see this in inflation expectations. So I like to look at the CPI swap market and one year swaps, you know, moved up a lot. But as you look at forward rates, if you look at the one year rate, one year forward and the one year rate two years forward, and the one year rate three years forward, they haven't really moved. If anything, they're actually down since the January FOMC. So, and, and, and you know, they haven't really moved much in response in, in response to the Iran shock at all. So if we changed 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, 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 of the traditional wisdom on, I mean, I'm very, as you can tell from the speech and you know, other things that I've, 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. And on wanna shift to unemployment, unemployment's sort of been in this in between sort a three and a 5% handle in the past few years. It's sort of a sort of inched up little by little, but hasn't really, it's, it's still very low compared to, you know, the 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 for employment?

- So the labor market, you know, was, you know, extremely tight in 20, 21, 22. And then in, you know, in, and then as the Federal Reserve started, its, its tightening policy, sorry, tightening cycle. The labor market set into a, a very gradual cooling trend. That trend's been in place for three years. I think given labor markets tend to show a lot of momentum, they tend to show a lot of, a lot of persistence in an underlying trend. And that this trend has been going on for three years. It seems to me that it should be the null hypothesis when you're thinking about, when you're thinking about how the labor market has changed. I haven't seen anything that's convinced me that this three year long trend has, has adjusted. There are, there are some folks who think that labor market is showing signs of stabilization. You know, I think that, I think the trend has, has continued and therefore mirror its additional support from monetary policy. Monetary policy is modestly restrictive and I don't think that the labor market really calls for that.

- Got it. Wanna shift to R star? So, you know, the fed's fed funds rate is between three and a half, three, 3.75. Do you think monetary policy right now as restrictive, neutral or accommodative? I mean, do you think R star, this sort of measure of, you know, if the, if the Fed had interest rates at that level, then inflation would be neither accelerating or decelerating. Do you think R STAR has sort of recently risen in that the, you know, over the past few years as, as some people have claimed? And how do you think about measuring R STAR in general? Do you like model based estimates? Do you like survey based estimates that New York Fed's surveys of macro expectations, they out these sort of survey estimates from market participants of R star? I'm a big fan of those or do you have your own models? How do, how do you think about R star? I know, I know you've spoken about this in the past each of years.

- Yeah, so I like, I like model estimates. So first of all, our R star is the neutral rate of monetary policy. It's the rate that's neither accommodative nor stimulative for the economy. If you're at neutral, you're not hitting the gas or the brakes, you're coasting. If you're above neutral, you're hitting the brakes. If you're below neutral, you're hitting the gas. And I, I I, and it's very difficult concept to measure. It's, it, it doesn't, you know, it's an abstraction. It doesn't exist in the real world. You know, you can, I can tell you the interest rate on a treasury bond, I can't tell you, you know, I can't go out and sort of find our star. It has to be estimated, right? And so I, I tend to like some of the time series methods for estimating our star, however, they take quite a while I think often to update and the world changes more quickly than they can arrive at arri arrive at new estimates in some, in some cases. And so I like to sort of start with that and then sort of adjust it with things, salient things in the economy that I think are first order importance that have, that have changed. And so what I'll do is I'll, I'll sort of start with that and I'll think about something like, and I've talked about this a lot, think about something like population growth, right? Population growth is something that, you know, I think is not controversial to think of it as affecting our star. I think that's a very well accepted concept. It wasn't that long ago that we were all talking about ification of the whole world because, you know, converging fertility rates coming down and, and demographics and aging and was that gonna lead to low interest rates everywhere, right? You know, that that conversation is very common pre COVID. And I think those, those pathways, you know, I I I think are, are are are good or valid pathways. I don't think they ever went away. Just other stuff happened in the meantime that we sort of, you know, we're paying attention to other stuff. But I think those economic mechanisms have always been valid and we just had the largest population growth shocks of our lifetimes in both directions in the last few years, right? We had a huge population growth spike and then a huge decline in population growth related to changing border policies in the last few years. And so it totally 180 and so the idea that that wouldn't sort of feed through into short run neutral rates that had consequences from Ontario policy is, you know, is, is is, you know, is is sort of, is sort of strange to me. So I will tend to sort of think, okay, let's take some of these, some of these models that, that do a good job of estimating these things, but maybe they're a little bit slow to adjust to something like that and then, and then adjust them based on some salient changes that I think will, will be relevant for it.

- So like the, the Lawback Williams and Lu Mathis.

- Yeah, I, I I think those are, those are, those are, that's great work. Yeah.

- Well, I want to talk just a little bit about Journal of ai. AI I feel like is something that is just pervasive right now, but it seems to come up quite a bit in monetary policy conversations as well. I mean, how do you see one generative ai, let's start I guess with the labor market, any thoughts on how generative AI is is, you know, potentially gonna affect labor market in the future?

- Sure. I mean, we may already be seeing it. You know, the labor market is, is weakest for new entrants and, and, and reran to the labor market. And, you know, those are, those are areas that generative ai, you know, sort of is arguably, is arguably affecting. And by the way, the fact that those labor, that those labor market segments seem weak seems to me an argument against assuming that low payroll growth is a function of border policy. I think a lot of people like to dismiss low jobs numbers as a result of changing border policy as being a negative labor supply shock. If that were the case then cohorts that were sharp substitutes that were strong substitutes for, for immigrant labor would be, would have the hottest labor markets in the country and they'd be experiencing rising, rising wage growth. You know, if you sort of hold demand constant and reduce supply, you get higher prices and you don't see that in the data, especially in a period of high productivity growth, you would expect to see much sharper, much stronger wage growth. And so to me the labor supply story isn't really consistent with it. I wanna say something else about ai, which is that, you know, 1, 1, 1 criticism that I've heard, that I've heard people make is that we keep getting these negative supply shocks and the, and the Fed keeps asking people to look through the negative supply shocks. Look, oil absolutely is a negative supply shock. And as I explained before, it doesn't affect the economy on a timeline unless there's changes to inflation expectations or a wage price spiral, which is not happening. It doesn't affect the economy in a timeline that monetary policy can respond to. But there also are positive supply shocks and AI is a great example of a positive supply shock. AI allows people to do more with less, right? It boosts productivity, it reduces barriers to entry, it allows people to produce more fewer inputs. That's a positive supply shock that really matters for economic growth, for inflation, for unemployment and for monetary policy. And all of that is, and all of that is really something that's very important that I think we need to take into account. Another positive supply shock is the change in, is the change in the regulatory environment. I gave a speech in January in Greece in which I looked at the lit, the modern literature, some of which is by your Hoover colleagues, Patrick McLoughlin. I looked at the modern literature on, on trying to quantify the regulatory code and there's people like Patrick and, and Joseph Kitz who do very, who do very good work using modern AI and machine learning and quantitative methods to reduce the regulatory code to numbers that you can then study. And I used this literature and I calculated that the deregulatory shock that's been ongoing since last year would weigh on inflation by about half a point per year over the next few years. Now there was a federal reserve research paper that was published a couple weeks ago by two fed staff economists, Danilo Kadi Garcia, and Mateo Yako Yako, who using an entirely different quantification method and an entirely different empirical method came up with a, you know, did similar estimates of the deregulatory shock we're living through. And if you apply their model to the size of the deregulatory shock that they estimate, it causes about a 30 basis point drag on inflation reduction in inflation per year for the next few years. Right. So I estimated about a 50 basis point persistent drag. They estimated about a 30 basis point persistent drag. I think those two are within noise of each other. I wouldn't, you know, I wouldn't reject 30 basis points as being outside of the conference spans, given the uncertainty in these things. But this is an example of a positive supply shock. Like AI is another example of a positive supply shock that I feel is underappreciated in all of the talk about negative supply shocks. And whereas oil is generally a one-off shock, again, unless there's changes to inflation expectations, unless there's a wage price spiral, neither of which is happening. Both AI and deregulation are gonna have persistent effects when you look at the way that these models work. And so as a result, these are things that I think are, are, are gonna be, are are gonna be pushing out the supply side and we all know their supply and demand. And if you hit the, if you hit the gas on demand while you're holding supply constant, you get inflation, right? If you push out supply as well, you know, you're not gonna get inflation.

- So, so I guess taking it all together, would you say that AI will push the neutral rate down or, or, or up in your mind?

- No, so AI definitely pushes the neutral rate up. And so it, you know, so I gave a speech on my view on the neutral rate in September. It was the first speech that I gave as a member of the Federal Reserve Board. And in that speech I described a number of policy changes that I thought had pushed around the neutral rate and, and a lot of them brought the neutral rate down, things like population growth, things like reduced fiscal deficits due to tariff revenue. AI is something that pushes the neutral rate. Higher deregulation also pushes the neutral rate higher by improving productivity. Positive supply shocks will push the neutral rate higher because they improve the return on capital. Now in that paper I started at what I thought was a very high neutral rate, and then I applied sort of changes from population growth and increased fiscal revenue, you know, decreased national borrowing, and then I came down to a low level. So in, in, you know, I started probably at the top end of the range of my colleagues and then I ended up at the bottom of the end of the range of my colleagues. But in neither case was I, was I above them? But I baked AI into my, into my sort of starting points or I tried to

- That That's, that's fascinating. I guess now that you bring up any, any just thoughts on, on fiscal and you know, we often talk about, in your paper you actually mentioned this idea of for regulatory dominance. We'd love to hear a bit about that because we often hear about, you know, fiscal dominance, monetary dominance. There's a lot of takes right now about, you know, the size of the federal debt. You know, it's obviously been ballooning over sure many decades and, and not just in the US but many, many countries in Japan being one of them. How, how does that in your mind, sort of affect the sort of constraints of, of central bankers?

- Sure. So look, you know, the, in the long, in the long run we need to get our fiscal house in order. In the shorter run, I think that I, I I think that, I do think that tariffs have started raising revenue that changed some of the trajectories in, in the short to medium run. Now they don't, I don't see them solving the very long term budget issues, which of course matter for the, for the interest rate market and for things that matter to monetary policy and our star and, and the economy. But I think in the short term, in the medium term, those dynamics have definitely changed. So the, you know, if you expect about a point and a third of GDP of additional revenue from tariffs or, you know, per year over the course of a decade, I think that's a pretty powerful reduction in reduction in the deficit. Also, you know, better productivity growth, better GDP growth also improves, improve the deficit because revenues will go faster than outlays. And so between the two of those, I think it's not far fetched to think that the primary deficit can get better by a couple points of GDP, which of course again, does not solve our fiscal problems on a multi-decade timeline, but it will ameliorate those problems over the course of coming years. Right? So I do think that this is, this is an area for important work, but I think things have gotten, have gotten somewhat better in the recent past too. And I think that that starts, that's starting to be evident in the data. And so if you look at the time period after tariffs were implemented, if you look at calendar Q2 through Q4 of 2025 versus calendar Q2 through Q4 of 2024, you see the deficit starting to come in. Now, not all of that is tariffs, not by any means, but it's come in by, by hundreds of billions of dollars. And so I think that that, I think that that is, is, is worth acknowledging.

- Yeah, I mean, I, I guess some you, there's some possibility of, of refunds, but of course, you know, the, i the administrations, you know, said they're gonna reinstitute these tariffs using 2 32 and, and 3 0 1 and other other methods. This is, you know, really, you know, such a fascinating conversation and, you know, it's a, it's a real honor to have you, Steve, really, I, I know your term is, is already expired and that, you know, that Kim war has been nominated to replace, to be put into your seat, at which point you'll leap. But, you know, it wouldn't surprise me at all if, if you're renominated to Jay Powell when he leaves, potentially shortly after. But really, this has been a fascinating conversation. I think your, your paper is again, very bold in, in talking about Fed Balance sheet reduction. You know, it's a topic that caused you massive consternation in treasury markets in, in years past with, you know, the taper tantrum and obviously the re repo crises of past years. But I really admire you for, for trying to take it head on. I really wanna thank you, Steve, for, for coming and a again, this is a live recording of the capital and freedom of the training first Century podcast, official podcast with the Hoover Institution, where we talk about economics, markets, and public policy. I'm Don Harley, your host. Thank you so much for joining us Steve.

- Thanks so much for having me.