Fed's Hammack Sees Steady but Cautious Path for Balance Sheet Reductions

Federal Reserve Bank of Cleveland President Beth M. Hammack has emerged as a key voice advocating for a deliberate, data-driven approach to shrinking the Fed’s balance sheet—a process now entering its fourth year. While her stance supports continued quantitative tightening (QT), her recent remarks emphasize a slower pace to mitigate market risks, ensuring stability as the Fed navigates an uncertain economic landscape.

The Current QT Framework
Hammack’s position aligns with the Fed’s March decision to slow balance sheet runoff, reducing the monthly cap on Treasury securities maturing without reinvestment from $25 billion to $5 billion. The $35 billion cap on mortgage-backed securities (MBS) remains unchanged. This adjustment reflects her belief that gradual reductions are critical to avoid destabilizing money markets. As of early 2025, the balance sheet stands at $6.8 trillion, down from a peak of $9 trillion during the pandemic, with reserves now at $3.3 trillion—still far above the “ample” threshold of $1–2 trillion.

Hammack argues that excessive reserves risk fostering complacency in markets, citing concerns over inflated invoice spreads and basis trading as evidence of distorted liquidity conditions. “A smaller buffer in normal times reduces the risk of over-sequestering Treasury collateral, which limits market liquidity,” she noted in a February speech.

Key Challenges and Considerations
1. MBS Portfolio Management: The Fed’s $2.2 trillion in agency MBS poses a persistent challenge. With many of these securities featuring low prepayment rates and extended maturities, Hammack questions whether to allow passive runoff or accelerate sales. “The decision requires careful calibration to avoid unintended market impacts,” she said.
2. Standing Repo Facility (SRF) Enhancements: Hammack advocates refining the SRF to reduce stigma and improve reserve distribution. Proposals include morning operations and aligning the SRF’s minimum bid rate closer to the interest on reserves. These changes aim to reinforce market discipline while maintaining a “just-above-ample” reserves framework.
3. Balance Sheet Composition: A transition toward Treasury-heavy holdings is a long-term priority. Hammack highlights the need to minimize the Fed’s indirect influence on credit allocation—a goal complicated by lingering MBS holdings.

Implications for Investors
The Fed’s cautious approach has direct ramifications for fixed-income markets. Slower QT reduces near-term pressure on bond yields, potentially supporting U.S. Treasuries. However, Hammack’s emphasis on “acceptable volatility” in overnight markets suggests investors should brace for periods of yield spikes.

Bank stocks, meanwhile, may benefit from narrower yield curve pressures as QT reduces excess reserves. “A gradual process allows banks to adjust their liquidity strategies without abrupt dislocations,” she explained.

Economic Scenarios and Policy Flexibility
Hammack outlined three potential paths for the economy:
- Scenario 1: Rate cuts if labor markets weaken and inflation eases.
- Scenario 2: Rate hikes if inflation persists despite strong employment.
- Scenario 3: Difficult trade-offs if inflation rises while employment declines.

Her stance underscores the Fed’s commitment to flexibility, with balance sheet decisions tied to real-time data rather than rigid timelines.

Conclusion: A Delicate Balance
Hammack’s cautious, data-dependent approach to balance sheet reduction aims to thread the needle between normalization and stability. With reserves still elevated at $3.3 trillion and QT proceeding at a slower pace, investors should anticipate a prolonged period of gradual shrinkage.

The Fed’s balance sheet has contracted by over $2.2 trillion since 2022, yet challenges like the MBS portfolio and market volatility remain. Hammack’s emphasis on the SRF and compositional shifts toward Treasuries signals a strategy to minimize disruptions while achieving normalization. For markets, this means staying attuned to Fed communications, money market dynamics, and evolving economic data. As Hammack herself noted, “The path forward is clear, but the pace must remain adaptable.”

In sum, Hammack’s leadership reinforces the Fed’s resolve to avoid abrupt policy shifts, ensuring QT remains a tool for stability rather than a source of instability. Investors who align their strategies with this gradualist framework may better navigate the evolving monetary landscape.