Morgan Stanley: After Waller's Jackson Hole Speech, Balance Sheet Runoff May Become the Fed's Second Policy Tool
nashnova research
Fed Chair Kevin Warsh reaffirmed the 2% inflation target at Jackson Hole and called the policy rate the "primary tool," pushing rate-hike pricing higher; but Morgan Stanley argues balance-sheet runoff is emerging as a second policy lever — and the trade-off between the two will reshape how markets price the Fed.
What did Warsh say, and why did markets move immediately?
Warsh reaffirmed the 2% inflation target at the Jackson Hole symposium, calling the policy rate the "primary tool" and saying other tools should be "used sparingly, if at all."
Markets repriced year-end rate-hike odds higher right after the speech. This means → the market read the remarks as a hawkish signal: when the chair himself confirms rates come first, hike probabilities go up.
Morgan Stanley, however, sees a deeper message — not about rate hikes per se, but about Warsh's longstanding views on the balance sheet.
Why does Warsh link the balance sheet to inflation?
MS chief global economist Seth Carpenter cited Warsh's pre-appointment interview at the Hoover Institution: Warsh explicitly views the Fed's roughly $7 trillion balance sheet as the root cause of above-target inflation.
In plain terms = Warsh's logic chain runs like this: the balance sheet is too large → it has injected too much money into the system → excess money keeps inflation elevated.
That chain produces a key substitution relationship: the more the Fed shrinks the balance sheet, the less it needs to raise rates. This means → rates and runoff are not additive — they are trade-offs. That, Morgan Stanley argues, is the signal markets are underpricing.
How large is the runoff Morgan Stanley expects?
In a recent report, Morgan Stanley forecast the Fed will launch a balance-sheet reduction of $1.5 trillion or more next year.
Carpenter said runoff "will indeed come," but he differs from Warsh on how runoff transmits through the economy to inflation. This reflects a gap: even when Wall Street and the Fed look in the same direction, they disagree on the transmission mechanism.
In plain terms = MS agrees the shrinkage is coming, but its view of how money moves from the financial system into the real economy — and then into prices — is not the same as Warsh's.
How strong is the hike pressure inside the FOMC?
Three members already voted for a hike at the July meeting — the hawkish camp is not a fringe voice.
If summer inflation data fail to show a convincing retreat, the FOMC will hike — and Warsh will not let himself end up on the losing side of the vote.
This means → whether Warsh's "runoff-for-hikes" framework can work depends on inflation data cooperating; if the data don't cooperate, a rate hike remains the default.
Why does pricing just get harder from here?
MS originally forecast no hike this year, conditional on inflation staying tame enough for the FOMC to stand pat. But Carpenter notes the key question has shifted from "hike or not" to "if so, how much" — and the answer depends on how much tightening the balance sheet absorbs.
In plain terms = markets used to guess one variable (rates); now they must guess two (rates + balance sheet) at the same time — double the complexity.
Whether Warsh's framework can truly deliver less hiking in exchange for more runoff is the central suspense the market will track through the coming data window.
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