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Kevin Warsh’s attempt to shrink the Federal Reserve’s balance sheet would proceed only slowly as Donald Trump’s nominee to chair the central bank faces resistance over his plan to scale back one of its most powerful tools.
Warsh has repeatedly said the Fed’s almost $7tn balance sheet is a reflection of how the central bank has strayed into Congress’s domain and noted its huge bond purchases under successive quantitative easing programmes have distorted financial markets.
But Warsh would only seek to make changes to the Fed’s balance sheet after extensive talks on its potential effects with banks and the broader public, according to people familiar with his thinking.
He would also be unlikely to push for a return to the size of the Fed’s balance sheet before it ballooned in response to the 2008 financial crisis, these people said, adding that he would call for internal research and academic conferences on the topic before taking action.
Warsh’s views on the Fed’s balance sheet are being closely scrutinised on Wall Street and are set to be a major point of discussion within the central bank if the Senate confirms him to replace Jay Powell as chair in May.
Some of the Fed’s most senior officials say shrinking the balance sheet would risk creating turmoil in money markets and imperilling policymakers’ ability to control short-term interest rates.
“You don’t want banks every night of the day digging around in the couch cushions looking for money,” said Christopher Waller, a Fed governor who lost out to Warsh in the race to replace Powell, at an economics conference in Washington last week. “This is massively inefficient and stupid.”
The central bank has shrunk the balance sheet from $9tn to $6.6tn over the past three years through a so-called quantitative tightening programme under which maturing bonds have not been replaced. But it remains larger than before the coronavirus pandemic.
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Rate-setters on the Federal Open Market Committee believe it would be difficult to shrink the balance sheet further right now.
The FOMC in December halted QT after bouts of stress in funding markets, which officials viewed as a sign they were on the brink of pulling too much cash out of the financial system.
Fed officials said the strains showed that banks no longer held “excess” reserves in the financial system, with levels now at an “ample” amount.
The Fed also acknowledged its balance sheet is likely to grow again this year as banks’ desire to hold reserves expands in tandem with the growth of the US economy. That would raise the amount of reserves that would need to be in the system to avoid falling below the ample level.
The current system of targeting ample reserves, which the central bank embraced in 2019, contrasts with the Fed’s reserve regime when Warsh joined the Fed as a governor in 2006. At that time, reserves were “scarce”, with lending between financial institutions taking on a far greater role in influencing short-term borrowing costs.
Under the ample regime, the Fed encourages banks to park their reserves at the central bank, rather than loan them out, by paying them interest — a so-called “floor system” which gives the central bank more control over short-term borrowing costs but removes incentives for interbank lending.
George Selgin, a former senior fellow at the Cato Institute, said: “If we’re serious about reducing the balance sheet, you have to get away from the operating system that tends to cause it to keep growing — and that’s the so-called floor system.”
The ample reserves regime has broad support on the Fed’s board, with governor Michelle Bowman the only governor to push for a return to scarce reserves.
Waller on Tuesday criticised the idea of returning to a scarce reserves regime, saying it fundamentally contradicted one of the main objectives of economics. “The objective is to reduce scarcity — that always improves welfare — not creating more scarcity,” the Fed governor said. “Scarcity is not the objective in economics. It never has been and it never should be.”
While Warsh’s remarks have led to suggestions that he will push for a return to a scarce reserves regime, he has not publicly used this language.
Warsh also believes the 2008 crisis showed the risks to financial stability of delegating too much responsibility to the interbank market, said people familiar with his thinking, and has publicly advocated for a “third model” of managing the Fed’s balance sheet.
Some regional Fed presidents would consider a measured shift to a new model of managing the balance sheet.
Austan Goolsbee, the head of the Chicago Fed who has worked with Warsh in the past when the Fed chair nominee was a central bank governor, last week said he would “personally be open to thinking through all of the ways that we can maintain [interest] rates”.
Goolsbee emphasised that any shift from the current regime would “require a lot of study”.
Fed governor Stephen Miran, who like Bowman and Waller were appointed to the Fed by Trump, has proposed shrinking the balance sheet by relaxing supervisory requirements in a way that would lead lenders to want to hold fewer reserves and more US Treasury debt.
Miran’s idea has gained some traction internally, with the influential head of the Dallas Fed, Lorie Logan, and Waller both signalling the idea deserves to be looked at.
Waller said: “Right now [the amount of reserves banks want to hold at the Fed] is around $3.1tn. Could it go to $2.5tn with some regulatory changes? I am sure it could.”
Data visualisation by Ian Hodgson in Washington
Join Claire Jones and FT colleagues on Thursday April 16 at 1pm (GMT) for a subscriber webinar exploring the future of the greenback, monetary policy and the global financial system under Kevin Warsh as Fed chair. Register now and send us your questions.
