How does the Fed lower its balance sheet? They sell the debt back into the market that they previously bought.

Nope.  The Fed injected liquidity INTO the system by buying Fed Funds and now MBS.. This injection is REMOVED by those assets being paid back.  The Fed COULD reign things in by simply NOT PURCHASING ANYMORE debt instruments.. THEN as they are paid off Remove the money supply... which is what I believe they are Currently doing and will continue to do.

If they injected $2 Trillion into the system since 08.. as these bonds are paid off.. they are using part of the proceeds to RE-INVEST in the system... aka with the current MBS buying program.

The Fed has been carrying the load.. I believe they are going to look more from the other powers in Washington to ALSO start pulling the load..

"Congress and the Executive.. it's your move."

If we can only afford 2/3rd's of the Government that we currently have.. I would FIRE everyone and start over.. 

"Okay.. you used to be this department head.. and you've offered to work at 2/3rd's the rate... hmmm.. a) not sure we NEED that department anymore.. and b) IF we do.. I've got this offer from someone else to do it for $.50 on the dollar.."

That is how I would do it...

btw this would ALSO reign in this supposedly coming inflation.. aka the coming fiscal cliff is gonna be deflationary.. therefore, I dont believe the Fed has to be in a hurry to get back to it's long term uptrend about $1.7 Trillion below it's current balance sheet...

"I could be wrong."

edit add:  I do TOTALLY agree with this statement though..

But untill congress quits spending massive amounts of money more than what they take in for income, there is no hope.

One Congress Critter from Washington state says we need to GO OVER the Cliff... hmm...???  Short of Congress coming to it's senses... might not be a bad idea.. naw SURELY Congress will come to it's senses... hmmm...?? 

Better cinch up the sealt belts..