Kevin M. Warsh sees the Federal Reserve’s more than $6 trillion portfolio of government bonds and mortgage-backed securities as emblematic of everything that has gone wrong with the central bank he now leads.
That portfolio — known as the Fed’s balance sheet — has grown increasingly large since the 2008 global financial crisis. Mr. Warsh wants the Fed to have a smaller footprint in financial markets and for there to be closer coordination with the Treasury Department on what the Fed holds in its portfolio and what the government issues in terms of debt to fund itself.
Here’s everything you need to know about the balance sheet and why the new Fed chairman wants it to be smaller:
What’s on the Fed’s balance sheet?
The Fed’s balance sheet reflects its assets and liabilities.
Its assets include over $4 trillion in Treasury securities and $2 trillion in mortgage-backed securities amassed in past crises as an attempt by the Fed to keep a lid on rates and support the economy.
Its liabilities include extra cash deposits that more than 5,000 banks hold at the central bank, otherwise known as reserves. The amount of reserves fluctuates with the amount of assets the Fed holds. Currency in circulation and the Treasury’s cash coffers represent the central bank’s other major liabilities. At its peak in 2022, its balance sheet totaled nearly $9 trillion.
Why is the balance sheet so large?
The Fed began buying large amounts of government debt and mortgage-backed securities during the global financial crisis. The central bank had already slashed short-term interest rates to near zero, but the economy and financial system were still under acute pressure.
So the Fed engaged in what’s known as “quantitative easing” (QE) — a program that sought to lower long-term interest rates by buying up large amounts of financial assets.
Mr. Warsh, who was a Fed governor during the financial crisis, was publicly skeptical of quantitative easing. He ultimately resigned from the Fed in 2011 over disagreements related to how much the central bank was relying on this tool.
The crisis fundamentally changed the Fed’s relationship with financial markets. Since 2008, the Fed has operated an “ample reserves” system to carry out its monetary policy. That entails the Fed supplying more than enough reserves to meet banks’ demands and paying interest on those holdings to create a “floor” for borrowing costs. When the Fed changes the target range of its main policy rate, it either raises or lowers the interest it is paying on those holdings such that rates across the financial system shift accordingly. Before the financial crisis, reserve balances were significantly lower and the Fed was not paying out interest, requiring frequent interventions to ensure supply and demand balanced out.
Last year, reserves dipped below $3 trillion following a three-year period in which the Fed reduced its holdings. Strains soon emerged in short-term markets, where banks and hedge funds borrow cash overnight for trading and to cover daily payments. The Fed reversed course, and in December began buying Treasury bills, which mature in one year or less.
Why does Warsh want to shrink the balance sheet?
According to Mr. Warsh, the Fed’s decision to expand its portfolio by so much and so quickly since the 2008 global financial crisis has stoked inflation, worsened inequality and distorted the process of how financial assets are priced. The growing size of the investments on its balance sheet has jeopardized the Fed’s own independence by treading into territory far outside its congressional mandate, he believes. And it has made Wall Street overly reliant on the Fed, creating an unhealthy expectation that the central bank will always be ready to ride to the rescue.
Mr. Warsh’s plan to rectify this appears, on the surface, relatively straightforward. He wants the Fed to have a smaller footprint in financial markets and for there to be closer coordination with the Treasury Department on what the Fed holds in its portfolio and what the government issues in terms of debt to fund itself. Mr. Warsh has argued that reducing the central bank’s holdings will give officials space to lower interest rates, something President Trump has long desired. The rationale is that longer-term rates are likely to rise as the balance sheet shrinks, which then could be offset by lowering short-term rates.
How would Warsh shrink it?
Efforts to shrink the balance sheet in the past have caused significant panic in financial markets. The last major episode was in 2019, when policymakers reduced the balance sheet by too much, causing short-term interest rates to spike. Even as recently as last year, the Fed had to deal with fresh volatility, prompting it to start buying short-dated Treasuries again.
Mr. Warsh is cognizant of the potential pitfalls of his balance sheet ambitions, telling lawmakers at his confirmation hearing that there would be an extensive debate before proceeding slowly with advance notice to markets.
While Mr. Warsh declined to say how much smaller he wanted the overall balance sheet to be, he made clear that the Fed should no longer be holding long-term Treasuries, given his concerns that doing so blurs the line between monetary and fiscal policy by suppressing the government’s borrowing costs.
Discussions around reducing the balance sheet have multiplied since Mr. Warsh’s ascent to Fed chairman. For some, the objective itself is questionable. Those in this camp argue that the current system works well because it is simple, requires minimal intervention and allows for the Fed to maintain a firm grip on rates.
One of the most vocal detractors of a significantly smaller balance sheet has been Christopher J. Waller, a governor who at one point competed with Mr. Warsh for the top job.
“You don’t want banks every night of the day digging around in the couch cushions looking for money,” he said at a conference this year. “This is massively inefficient and stupid.”
What he has conceded, however, is that there is a path to reducing banks’ demand for reserves as a mechanism to shrink the balance sheet that would not jeopardize the Fed’s current system for enacting monetary policy.
Recent research points to several ways to achieve that. The most popular path revolves around altering regulations to reduce banks’ need to hold reserves.
Mr. Warsh is cognizant of the potential pitfalls of his balance sheet ambitions, telling lawmakers at his confirmation hearing that there would be an extensive debate before proceeding slowly with advance notice to markets. That echoed Treasury Secretary Scott Bessent, who said it could take up to a year for the Fed to make any balance sheet decisions.
