Kevin Warsh’s reported ambition to significantly shrink the Federal Reserve’s balance sheet is likely to encounter stiff resistance from the structural realities of the United States financial system, according to economists and market analysts.
Warsh, nominated by the Trump administration to succeed current Fed Chair Jerome Powell when his leadership term ends in May, has long criticised the central bank’s heavy reliance on bond holdings as a policy tool.
However, while a smaller balance sheet may be politically and philosophically appealing, experts argue it could prove difficult to achieve without fundamental changes to the way the financial system operates.
At the core of the challenge is the framework the Federal Reserve now uses to implement monetary policy. Since the global financial crisis and the pandemic-era interventions of 2020, the Fed has relied on a system that requires banks to hold substantial reserves.
The abundance of liquidity underpins the central bank’s ability to steer short-term interest rates using administered tools.
Breaking that equilibrium would likely require changes both to the Fed’s rate-control mechanisms and to regulatory settings that shape banks’ demand for reserves. Without such adjustments, a sharp contraction in the central bank’s holdings risks destabilising short-term funding markets.
Stephen Cecchetti of Brandeis University and Kermit Schoenholtz of New York University argued in a recent blog post that while a large central bank balance sheet can facilitate government financing in ways some view as undesirable, reducing it too far could create new problems:
“Unless there are major changes in the Federal Reserve's operations or in regulatory arrangements, shrinking the balance sheet risks significant interest rate volatility that could undermine financial intermediation and credit provision.
"Reducing reserve demand by relaxing liquidity requirements could leave the banking system more vulnerable to a panic.”
Under current rules and with the existing rate-control toolkit, they warned that significant balance sheet shrinkage “would expose short-term markets to substantial volatility risk – a cure potentially worse than the disease”.
Warsh, who previously served as a Fed governor from 2006 to 2011, has made the balance sheet a focal point of his critique. He has argued that the Fed’s vast holdings distort financial markets and disproportionately benefit Wall Street over Main Street.
In his view, further contraction could free up liquidity for broader economic use and potentially allow the Fed to operate with a lower policy rate than otherwise necessary.
The Fed’s balance sheet expanded dramatically during two major crises. In response to the 2008 financial crisis and again during the COVID-19 pandemic, the central bank launched large-scale asset purchases of Treasury and mortgage-backed securities. These quantitative easing programmes aimed to calm stressed markets and stimulate the economy when policy rates were already near zero.
As a result, total holdings surged to nearly US$9 trillion (A$12.77 trillion) in the spring of 2022, levels once thought unimaginable. Even during two subsequent episodes of balance sheet reduction, the Fed never returned to its pre-crisis footprint.
In 2022, policymakers began a fresh round of quantitative tightening (QT), allowing securities to roll off the balance sheet in an effort to drain excess liquidity.
The process continued until late last year, when money market conditions began to tighten. A range of short-term rates edged higher, and some financial institutions were compelled to tap Fed facilities directly to manage liquidity needs.
Officials subsequently halted QT, judging that reserves had fallen to the lower bound of what was consistent with smooth rate control. The move stabilised increasingly choppy money markets.
Since its 2022 peak, the Fed has reduced its holdings to approximately $6.7 trillion, though it has recently begun modest rebuilding as a technical measure to maintain control over short-term rates.
Analysts say that as long as regulatory requirements and liquidity preferences keep banks’ reserve demand elevated, aggressive balance sheet contraction could unsettle funding markets and undermine policy implementation.
Some observers suggest that closer coordination between the Fed and the U.S. Treasury could create limited scope for a smaller balance sheet. Adjustments to Treasury issuance patterns, for example, might influence the distribution of liquidity in ways that reduce the burden on the central bank.
Even so, many Fed watchers believe that financial constraints will ultimately temper any radical push for change. A renewed round of QT is widely regarded as unlikely in the near term.
