Warsh may seek to reduce Fed balance sheet, but experts warn of difficulties

2 Feb (Reuters) – US President Donald Trump’s nominee to head the Federal Reserve, Kevin Warsh may want to significantly reduce the central bank’s multibillion-dollar balance sheet, but experts agree that financial reality indicates that achieving this goal will be difficult and slow, if at all possible.

This is because ‍the Fed reserves and the regime that has developed to manage interest rates, in a system with excess liquidity, are not easy to reduce while maintaining market stability and achieving monetary policy goals. It could be even more complicated for a Fed chair who is likely to seek lower short-term interest rates, because anything that significantly reduces the central bank’s bond reserves actually tightens financial conditions.

Warsh, who was a member of the Fed Board from 2006 to 2011, argued that the Fed’s large reserves distort the economy’s finances and that what the institution currently holds should be drastically reduced.

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In an op-ed published in the Wall Street Journal in November, he wrote that “the Fed’s bloated balance sheet, designed to support the largest companies in an era of past crisis, could be significantly reduced,” with resources being redistributed “in the form of lower interest rates to support families and ‌small and medium-sized businesses.”

Warsh’s call to reduce the Fed’s reserves came as the central bank neared the end of what turned out to be a three-year effort to reduce the volume of bonds acquired through aggressive purchases during the Covid-19 pandemic.

The Fed purchased Treasury bonds and mortgage bonds initially to help stabilize fragile markets at the start of the health crisis, with those purchases becoming a form of economic stimulus.

Emergency purchases doubled the size of the Fed’s reserves, reaching a peak of US$9 trillion in the summer of 2022 (June-September period in the northern hemisphere), before a contraction process known as quantitative tightening (QT) reduced total reserves to US$6.6 trillion by the end of 2025.

In December, the Fed began again increasing the stock of bonds it holds through technical purchases of Treasury securities in an attempt to ensure enough liquidity in the financial system to maintain a firm grip on its interest rate target.

More broadly, the use of the balance sheet as a tool has become an integral part of the monetary policy toolkit, and a crucial tool considering the increasing likelihood of short-term interest rate cuts to near-zero levels in times of crisis.

Meanwhile, the Fed has developed a whole system of tools to manage rates. And this is why significantly reducing asset reserves would be so difficult without generating market chaos.

Warsh “may want a smaller balance sheet and a smaller Fed presence in financial markets,” said Joe Abate, U.S. interest rate strategist at SMBC Capital Markets, Inc. But, “reducing the size of the balance sheet is out of the question… Banks want that level of reserves.”

Abate was referring to the fact that when banking system reserves fall to about $3 trillion, considerable volatility begins to emerge in money market rates, which threatens the Fed’s ability to manage its interest rate target. This limits how much the Fed can reduce its reserves.

In addition to market realities, there is also the fact that any significant change would need the approval of other members of the Fed, who have largely agreed with the general strategy of using the balance sheet as an instrument of monetary policy and could oppose efforts to revamp this part of the toolkit.

Long way

So how could Warsh reduce the Fed’s reserves, given the reality of what the market will bear? Analysts said easing some of the regulatory burden on banks’ liquidity management, along with measures to make the Fed’s credit lines — such as the Discount Window and ongoing repo operations — more attractive, could reduce the appetite for holding reserves and allow for a smaller Fed presence over time.

David Beckworth, a senior fellow at George Mason University’s Mercatus Center, said that in addition to these measures, Warsh could include, as part of the Fed’s existing periodic review framework, actions to reconsider how the Fed uses its balance sheet. There could also be coordination between the Fed and the Treasury, with the two institutions carrying out bond swaps, he added.

And while big changes may not be on the cards, there are ‌ways the Fed can adjust its tools to reduce the need to hold too much liquidity.

“The Fed is like a slowly turning ship, which is probably a good thing because you don’t want to cause major disruption to the financial system,” Beckworth said.

Analysts at Evercore ISI agree that any actions Warsh takes on the balance sheet will be slow and careful, taking into account the risks of an aggressive approach.

“We believe he will be more pragmatic than many expect,” the research firm said. “We believe he will promise no abrupt changes to Fed balance sheet policy and an agreement between the Fed and Treasury to provide a framework for closer cooperation,” the analysts wrote.

They added that “the market will interpret this as a concession to the Treasury Secretary. (Scott) Bessent exercises a tacit veto over any QT plans, and Warsh will be pleased with that.”