Warsh's ambition to shrink the central bank's multitrillion-dollar bond portfolio may quickly run into hard limits.

Why it matters: For nearly two decades, the Fed's ability to flood markets with liquidity has been among its most powerful crisis-fighting weapons — and, in Warsh's view, too often a go-to tool for monetary stimulus outside of crises.

• Now, the hot discussion among Fed officials and commentators is about how to responsibly shrink the Fed's asset portfolio — and whether that's even a worthwhile goal.

The big picture: The Fed's assets ballooned from about $800 billion before the 2008 financial crisis to nearly $9 trillion at its 2022 peak — swelling each time the central bank stepped in to stabilize the economy, particularly through open-ended quantitative easing programs starting in 2012 and 2020.

• Three years of runoff brought the balance sheet back to $6.7 trillion, though the Fed resumed slowly growing it again after signs of stress in critical funding markets last December.

What they're saying: Warsh has been a consistent critic of the size of the Fed's balance sheet and the intervention in financial markets that it generates.

• "As it's grown its balance sheet, grown its imprimatur on the economy, those with financial assets have benefited," Warsh said at his confirmation hearing.
• "If we were to cut rates, a broader number of people will benefit from it, versus quantitative easing, which tends to move through financial assets first."

Yes, but: Reducing the Fed's holdings could cause mortgage rates and other longer-term borrowing costs to rise.

• And if undertaken without first reducing demand for reserves in the banking system, it could destabilize money markets.
• "If in the near term we're talking about a significant decrease in the balance sheet, that seems incompatible in any comparable time frame with the view of potentially reducing interest rates," Roy Henriksson, head of investment risk and trading at investment firm GMO, told Axios on the sidelines of the Atlanta Fed financial markets conference.

Of note: Warsh seems well aware of the risks, and in his confirmation hearing emphasized the need to move "slowly and deliberately."

• "It took us 18 years to create this big balance sheet that's done quite a bit of harm," he said.

Zoom in: Sucking too much money out of the banking system risks a repeat of 2019, when the Fed's efforts to do just that forced a sharp reversal after money markets seized up.

• Former Chicago Fed president Charles Evans, speaking at the conference, said one way to shrink the balance sheet might be curbing banks' demand for reserves, cash that financial institutions park at the Fed — and the single biggest slice on the liabilities side of the balance sheet.
• But Evans was skeptical of proposals for doing just that — from Stephen Miran, Lorie Logan, Stanford scholar Darrell Duffie and others.
• "Personally, I worry that each of these are ambitious, substantial, Manhattan Project-like initiatives," Evans said, adding, "I have my doubts."

The intrigue: Roberto Perli, who oversees the Fed's markets operations at the New York Fed, said this week that a smaller balance sheet is possible if banks' demand for reserves shrinks, which could happen through regulatory changes.

• He did warn that draining too much cash from the banking system can go wrong fast.
• "The consequences" of misjudging, Perli said, extend "not only for rate control but also for the stability of repo markets and, by extension, the Treasury market."

What to watch: Warsh will find at least one colleague already on record against his agenda.

• In a speech last week, Fed governor Michael Barr said that shrinking the balance sheet is "the wrong objective," noting that proposals to do so "would undermine bank resilience, impede money market functioning, and, ultimately, threaten financial stability."
• Some proposals to reduce the Fed's footprint, he added, would paradoxically require more frequent Fed intervention in markets, not less.

The bottom line: "Any longing for the good old days of $800 billion is just completely unrealistic," Evans said.

Trump has spent much of his term bashing outgoing Fed chair Jerome Powell for not cutting interest rates enough. Yesterday, he seemed surprisingly blasé about the possibility that Warsh might end up raising them.

Driving the news: A reporter yesterday noted that markets now think an interest rate hike this year is more likely than a cut and asked the president whether he thinks Warsh will deliver the lower rates that Trump has long demanded.

• "I'm going to let him do what he wants to do," Trump said. "He's a very talented guy, he's going to be fine, he's going to do a good job."

Between the lines: That's not how defenders of Fed independence would prefer a president phrase things. Once a Fed chair has been installed, they don't need presidential approval for rate decisions; rather, they're supposed to carry out policy that will best achieve the central bank's statutory mandate.

• But Trump is seemingly giving Warsh some room to maneuver, implying that he may not immediately get the Powell treatment even if Warsh delivers a hawkish monetary policy message in his early months in office.

Of note: Last week, Treasury Secretary Scott Bessent said he thinks there will be one or two more "hot inflation numbers, but then I think we're going to see substantial disinflation."

• The early question for Warsh and the policy committee he inherits will be whether to look through the inflation surge being largely driven by energy disruptions tied to the Iran war.
• Minutes of the late April Fed meeting are due out today at 2pm ET and will shed further light on a meeting in which four officials dissented, three of whom wanted to remove language implying the next policy move will be toward lower rates.

By the numbers: The CME FedWatch tool, based on futures prices, now puts minuscule odds on rate cuts this year, with 39% odds that the Fed policy rate ends 2026 where it is now and 60% odds on at least one rate hike.