Overview
Kevin Warsh, the nominee to succeed Jerome Powell when his term concludes in May, has been vocal about reducing the Federal Reserve’s balance sheet. Yet several economists and market analysts caution that cutting Fed holdings substantially is not straightforward under the current monetary architecture. The central argument is simple: the Fed’s toolkit and the banking sector’s appetite for high reserve balances together set practical limits on how far the central bank’s assets can be pared back without destabilizing short-term funding markets.
Why a smaller balance sheet is not easy to achieve
At the heart of the challenge is the way the Fed secures control over monetary policy. Since the financial crisis and again during the COVID-19 crisis, the central bank has relied on large-scale purchases of Treasury and mortgage-backed securities to inject liquidity and calm strained markets when its policy rate could not be lowered further. Those interventions swelled the Fed’s holdings to levels once considered unimaginable - overall assets peaked at $9 trillion in the spring of 2022.
Although the Fed has tried to reverse some of that expansion through quantitative tightening, it has never reduced the footprint close to pre-crisis depths. The Fed’s framework, formalized with largely automatic rate-setting tools in 2019, allows it both to absorb and lend cash and to deploy special facilities to supply liquidity swiftly if markets fray. These mechanisms work in tandem to anchor the fed funds rate where policymakers want it. That same operational design, however, requires the banking system to hold relatively large quantities of reserves, which in turn constrains how much the Fed can shrink its balance sheet without jeopardizing rate control.
Views from economists and market analysts
Analysts at BMO Capital Markets emphasize the difficulty: there is not a simple route to a smaller Fed involvement in financial markets. They argue that materially lower System Open Market Account (SOMA) holdings may not be feasible absent regulatory reforms that reduce banks’ demand for reserves - reforms that would take quarters, not months, to execute.
Economists Stephen Cecchetti and Kermit Schoenholtz have warned similarly that a substantial shrinkage in the balance sheet under current rules and rate-control tools would risk significant volatility in short-term markets - an outcome they describe as potentially worse than the problems created by a large balance sheet. Their point is that the present configuration both facilitates government financing and alters market functioning, and that breaking the link without changing the rule set could be destabilizing.
Warsh’s stance and the mechanics he challenges
Warsh, who served as a Fed governor from 2006 to 2011 and was tapped by the administration late last month, has critiqued the use of the Fed’s bond and cash holdings as a persistent policy tool. He has argued that large Fed holdings distort financial markets and tilt benefits toward Wall Street rather than Main Street. He contends that channeling that liquidity more broadly into the economy could allow the Fed to set a lower interest-rate target than it otherwise would.
The practical counterpoint from many Fed watchers and market participants is that banks’ need for robust reserve cushions is what makes removing liquidity risky. If reserves fall too far, the Fed could lose the precision of its control over the federal funds rate, which is central to achieving its inflation and employment objectives. When the Fed attempted quantitative tightening beginning in 2022, the objective was to remove excess liquidity until the system reached a liquidity level low enough to permit continued firm rate control. That point was reached late last year when some money market rates began to rise and certain financial firms found themselves borrowing from the Fed to manage cash needs, prompting an end to QT as market strains emerged. The cessation of QT calmed volatile money market conditions and allowed the Fed to lower overall holdings from the 2022 peak to the current level of $6.7 trillion.
Options for reducing the balance sheet - and their limits
Many observers contend that shrinking the balance sheet materially would require a combination of changes. One path would be regulatory reform that lessens banks’ inclination to hold large reserve buffers. BMO analysts note that such reforms would be slow to implement. Morgan Stanley strategists acknowledged on February 6 that changing rules could reduce the desire for liquidity but cautioned that lower liquidity buffers could raise financial stability risks.
Another operational route discussed by analysts involves how the Fed provides intraday and standing liquidity. J.P. Morgan’s Jay Barry and Michael Feroli suggested enhancing on-demand loan provision via repo operations might give banks greater confidence to hold less cash. Even with such enhancements, they do not expect the Fed to restart quantitative tightening, a move that could signal to markets a reluctance to use the balance sheet in the future and thereby drive up borrowing costs today.
Tighter coordination between the Treasury and the Fed is another possibility some observers have raised as a way to create room for smaller holdings. Still, the broad consensus among many market watchers is that operational and regulatory realities will likely limit any rapid or dramatic shift away from the current balance sheet size, regardless of a nominee’s public statements.
Market implications and political considerations
Economists and analysts also point to the market signaling effect of policy actions. A return to aggressive quantitative tightening would communicate to investors that the Fed intends to forswear the balance sheet as an active tool in future crises. That signal alone could be costly: it might increase bond market borrowing costs now by changing market expectations about the central bank’s backstop role.
Evercore ISI analysts have indicated they do not expect a reversion to pre-financial-crisis policy conduct - a regime characterized by scarce market liquidity and frequent central bank interventions to manage interest-rate volatility. This underscores a prevailing view that, even if a new chair prefers a smaller balance sheet, the Fed’s operating procedures and market dependencies make a wholesale return to older paradigms unlikely.
Concluding assessment
In short, while Warsh’s preference for a smaller Fed balance sheet is clear and rooted in concerns about market distortions, the path to realizing that preference is constrained. The Fed’s current setup depends on significant liquidity in the financial system and on tools designed to keep short-term rates steady. To materially shrink the balance sheet without risking interest-rate control or elevating short-term market volatility would likely require regulatory changes to reduce banks’ demand for reserves, adjustments to how the Fed supplies on-demand liquidity, or closer coordination with the Treasury - each of which presents its own costs and timing challenges. Consequently, many observers expect financial and operational realities to temper any rapid or sweeping moves toward a much smaller Fed footprint.