How Kevin Warsh could shrink the $6.7T Fed balance sheet
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Kevin Warsh, President Trump's nominee to lead the Federal Reserve, has said repeatedly that he wants the central bank to have a smaller imprint on financial markets. Doing so will be easier said than done.
The big picture: That is the upshot of new research being presented Thursday by Stanford economist Darrell Duffie. He gives a menu of options for how the Fed could shrink its $6.7 trillion balance sheet.
- The good news for Warsh is that it's plausible to accomplish balance sheet shrinkage without major disruption to money markets. The bad news is that it involves complexity and trade-offs.
State of play: Before the financial crisis in 2008, the Fed's total assets were a dainty $900 billion, or 6% of U.S. GDP.
- After nearly two decades of quantitative easing and other programs to respond to crises, it's up to 21% of GDP.
- It includes a dog's breakfast of assets, including $2 trillion in mortgage-backed securities and some remaining stubs of assets left over from emergency programs during the pandemic and the 2023 regional bank crisis.
- But the flip side of those assets is the Fed's liabilities. That includes paper money and the U.S. Treasury's cash management account, but the biggest slice is bank reserves.
Zoom out: Mechanically, if the Fed were to try to slash its assets willy-nilly by selling them, it would involve sucking money out of the banking system, reducing reserves.
- But if it went too far, it would mean huge disruptions in the money markets — causing the Fed to lose control over short-term interest rates and potentially cause an unwanted contraction in credit more broadly.
- That's exactly what was starting to happen in a disruptive episode in 2019.
Zoom in: To make balance shrinkage work, Duffie will argue at the Brookings Papers on Economic Activity, it needs to be accompanied by steps to make banks want to hold fewer reserves — to ensure that it can proceed without those ill effects. He lays out several options for doing so:
- The Fed could adjust regulations so that banks feel less pressure to meet liquidity requirements by holding reserves at the Fed.
- It could change its payments systems so that banks don't need as many reserves for day-to-day transactions.
- It could create a tiered system so that banks that park more money than they need at the Fed as reserves earn less interest.
- It could act to offset seasonal shocks that happen to reserves at the end of each quarter.
The bottom line: Should the Warsh Fed seek a smaller balance sheet, "if you just do it without reducing demand for reserve balances, that won't work," Duffie told Axios in a call with reporters.
- "If you can do some of the things on my list, that will reduce the demand for reserves, then that can work," he said.
