After Waller's hawkish speech, the market focuses on "rate hikes", but Morgan Stanley says balance sheet reduction is more likely.

Waller reiterated the Federal Reserve's commitment to bringing inflation back to 2% in the mountains of Wyoming, and the market immediately priced in more rate hike expectations. However, Morgan Stanley's Chief Global Economist Seth Carpenter pointed out in his latest report that this reaction may overlook a key variable—balance sheet reduction.

Carpenter wrote that in July, Waller's stance on rate hikes was still unclear, stating only that rates "could be part of the solution." But at Jackson Hole, he clarified his position: the policy rate is the "main tool," and other tools should be used "as little as possible, if at all."

But this does not mean balance sheet reduction will be put aside.

Waller’s logic: The balance sheet is the root of inflation

Before becoming Federal Reserve Chair, Waller gave a more straightforward explanation of using the two main policy tools during an interview with the Hoover Institution.

According to Carpenter’s citation, Waller explicitly believes that the $7 trillion balance sheet is the fundamental reason for inflation running above target. At Jackson Hole, he listed “money” as one of the core principles of monetary policy operations and further stated: if the “money” created by the balance sheet is withdrawn, interest rates can be maintained at a lower level.

This logic is clear: balance sheet reduction→ tighter liquidity → inflation falls → rate hike pressure eases.

FOMC divisions deepen, and rate hike pressure is real

Morgan Stanley originally projected no rate hikes this year, on the condition that inflation would decline gently enough for the FOMC to forgo hiking.

But Carpenter points out that the FOMC decides policy by vote, and currently there are three dissents supporting a rate hike. If summer inflation data does not convincingly show cooling, a hike will take place.

"Waller will not allow himself to be on the losing side of the vote," Carpenter wrote.

This means that even if Waller personally prefers using balance sheet reduction over hiking rates, he will go along with a majority if the committee leans toward a hike.

Morgan Stanley expects: Next year’s balance sheet reduction may exceed $1.5 trillion

Carpenter stated that he does believe a balance sheet reduction is imminent. A recent Morgan Stanley report ("Global Economics and Fixed Income Strategy: The Federal Reserve's Balance Sheet Reform: More Reduction, Less Tightening") forecasts that the Fed may launch a reduction of at least $1.5 trillion—or even greater—in scale next year.

Carpenter also acknowledged that his view on how the reduction transmits to the economy and eventually affects inflation is notably different from Waller's. However, regardless of the transmission path, the conclusion is the same for the market:

When pricing in monetary policy, investors must consider both interest rates and the balance sheet as tools, which will bring additional uncertainty and debate.