Morgan Stanley Sees Fed Shrinking Balance Sheet by $1.5 Trillion

Morgan Stanley economists expect the Federal Reserve to shrink its balance sheet by roughly $1.5 trillion over about two years, a reduction that could begin as early as the first quarter of 2027 and would tighten financial conditions across rates, equities and credit.

"The reasonable range for the reduction is $600 billion to $2.5 trillion," Seth Carpenter and Michael Gapen, economists at Morgan Stanley, wrote in a report, laying out a baseline forecast that assumes the Fed resumes quantitative tightening after a pause. The pair said the pace and endpoint would hinge on how reserve scarcity develops once the central bank's holdings fall toward the level banks need to settle payments.

The forecast lands as the Fed holds its policy rate at 3.50 percent to 3.75 percent, unchanged since the July 29 meeting that passed on a 9-3 vote with three dissents. Chair Kevin Warsh has signaled tolerance for tighter financial conditions rather than offering forward guidance, and traders still price roughly a 59 percent probability of a 25-basis-point hike at the September meeting. The 10-year Treasury yield sits near 4.6 percent and the two-year near 4.2 percent, while spot gold jumped more than 4 percent to about $4,244 an ounce as softer labor data cooled the most aggressive tightening bets.

A $1.5 trillion reduction would drain liquidity from a system already absorbing the Fed's runoff, pushing up term premiums and borrowing costs across the economy. The last time the Fed ran a comparable unwind, from 2022 through early 2025, it cut its holdings by about $2 trillion, and the 10-year yield climbed roughly 150 basis points over that stretch before the central bank slowed the pace. Morgan Stanley's baseline implies a smaller, slower drain, but the upper end of its range would rival the prior episode in scale.

The timing matters because the Fed's balance sheet is intertwined with its rate path. If the central bank resumes tightening in September and then begins runoff in early 2027, the combined effect would compress equity valuations through higher discount rates and lift funding costs for banks and corporates. Morgan Stanley's forecast assumes the reduction proceeds without triggering the reserve scarcity that forced the Fed to halt runoff in 2019, when overnight rates spiked and the central bank intervened in repo markets. The next FOMC meeting, scheduled for September, will offer the first signal of whether the committee shares that view.

This article is for informational purposes only and does not constitute investment advice.