Dudley: Fed Balance Sheet Shrinkage, Down 25%, 'Wrong Way' to Lower Short-Term Rates

New York – Former President of the Federal Reserve Bank of New York, Bill Dudley, has asserted that significantly shrinking the central bank's balance sheet is an ineffective strategy for lowering short-term interest rates. This perspective, shared in a recent Bloomberg Opinion piece, directly challenges arguments suggesting that quantitative tightening (QT) could enable the Federal Reserve to cut rates. Dudley's commentary highlights a fundamental disagreement on the mechanics of monetary policy and the role of the Fed's balance sheet.

"Former New York Fed President Bill Dudley says significantly shrinking the central bank's balance sheet is the wrong way to lower short-term interest rates," stated a tweet from Bloomberg Opinion, summarizing Dudley's position. He specifically refutes the argument, notably made by former Fed Governor Kevin Warsh, that a smaller balance sheet would tighten financial conditions sufficiently to necessitate rate cuts. Dudley labels this view as largely a "fairy tale."

Dudley argues that the impact of balance sheet reduction on overall financial conditions is modest. He points to the fact that the Fed has already trimmed its balance sheet by nearly 25% from its 2022 peak of approximately $8.97 trillion to $6.64 trillion, yet financial conditions have remained relatively loose. This observation suggests that the size of the balance sheet does not have the profound effect on short-term rates that some proponents claim.

The former Fed official explained that the reserves created during quantitative easing (QE) primarily accumulated at the Fed, rather than directly fueling a surge in lending. He emphasized that credit growth is now largely determined by the interest rate the Fed sets on reserves, which acts as a floor for other short-term rates, rather than by the sheer quantity of reserves. This shift, initiated by the Fed's decision to pay interest on reserves in 2008, has effectively decoupled the balance sheet size from the money supply and broader economic activity.

Furthermore, Dudley warned that continuing to shrink the balance sheet too aggressively could lead to a scarcity of reserves, potentially impairing the Fed's control over monetary policy, as evidenced by the September 2019 repo market disruptions. He noted that abandoning the current "ample reserves" framework for a return to a "scarce reserves" regime would introduce significant operational complexities and undermine the central bank's ability to act as a lender of last resort during times of financial stress. For Dudley, the primary tool for managing short-term interest rates remains the federal funds rate and interest on reserves, with balance sheet normalization serving as a secondary, background adjustment.