To Kevin M. Warsh, the Federal Reserve\u2019s more than $6 trillion portfolio of government bonds and mortgage-backed securities is emblematic of everything that has gone wrong at the institution he hopes to lead.<\/p>\n
The Fed\u2019s 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, according to Mr. Warsh, who is awaiting confirmation to become the next chair. The growing size of the investments on its balance sheet has jeopardized the Fed\u2019s 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.<\/p>\n
Mr. Warsh\u2019s 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\u2019s 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.<\/p>\n
Achieving all of this will be anything but straightforward, however. It will take careful planning and a significant amount of time in order to avoid creating damaging volatility.<\/p>\n
There are already jitters about the direction that Mr. Warsh will push the Fed if confirmed by the Senate. His path to winning confirmation became much clearer on Friday after the Justice Department dropped a criminal investigation into the central bank. The inquiry had been a major roadblock to Mr. Warsh\u2019s ascent to become chair.<\/p>\n
Still, other hurdles remain. Among his first tasks will be to overcome lingering doubts<\/a> about how susceptible he will be to pressure from the president, who wants more influence over the institution.<\/p>\n But there is a second hitch as well. Fresh in the minds of Fed officials and investors across Wall Street is a 2019 episode in which policymakers reduced the balance sheet by too much, causing short-term interest rates to spike. That episode was a \u201cnear heart attack\u201d for markets, said James Clouse, who served as deputy director of the Fed\u2019s division of monetary affairs at that time, leaving a \u201cpretty profound, lasting impact on the way people have thought about the balance sheet.\u201d<\/p>\n That caution remains in force today.<\/p>\n \u201cIt\u2019s very clear that the balance sheet cannot be immediately reduced without causing a liquidity crunch that nobody would like,\u201d said Darrell Duffie, a professor of finance at Stanford University\u2019s Graduate School of Business. \u201cBoth the plan and the execution are going to make the difference between failure and success.\u201d<\/p>\n What\u2019s on the Fed\u2019s balance sheet?<\/p>\n The Fed\u2019s balance sheet reflects its assets and liabilities.<\/p>\n 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.<\/p>\n 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\u2019s cash coffers represent the central bank\u2019s other major liabilities. At its peak in 2022, its balance sheet totaled nearly $9 trillion.<\/p>\n Since 2008, the Fed has operated an \u201cample reserves\u201d system to carry out its monetary policy. That entails the Fed supplying more than enough reserves to meet banks\u2019 demands and paying interest on those holdings to create a \u201cfloor\u201d 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.<\/p>\n 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.<\/p>\n Mr. Warsh is cognizant of the potential pitfalls of his balance sheet ambitions, telling lawmakers at his confirmation hearing on Tuesday 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.<\/p>\n 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\u2019s borrowing costs.<\/p>\n How to Shrink It<\/p>\n Discussions around reducing the balance sheet have multiplied in anticipation of Mr. Warsh\u2019s ascent to Fed chair. 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.<\/p>\n 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.<\/p>\n \u201cYou don\u2019t want banks every night of the day digging around in the couch cushions looking for money,\u201d he said at a conference earlier this year. \u201cThis is massively inefficient and stupid.\u201d<\/p>\n What he has conceded<\/a>, however, is that there is a path to reducing banks\u2019 demand for reserves as a mechanism to shrink the balance sheet that would not jeopardize the Fed\u2019s current system for enacting monetary policy.<\/p>\n A slew<\/a> of new research<\/a> points to several ways to achieve that. The most popular path revolves around altering regulations to reduce banks\u2019 need to hold reserves.<\/p>\n Policymakers have zeroed in on the liquidity coverage ratio, which requires banks to maintain sufficient funding to meet their obligations for 30 days, as well as internal liquidity stress tests that assess how much an institution would need to weather a severe shock. There has also been a discussion about allowing banks to count whatever capacity they have to borrow at the Fed\u2019s discount window, a facility that provides short-term loans to banks, toward fulfilling their liquidity requirements.<\/p>\n Already, Michelle W. Bowman, the vice chair for supervision, has hinted<\/a> at rule changes to reduce \u201cliquidity hoarding.\u201d Regulators will have to be careful not to scale back too aggressively, however, or raise the risk that lenders will not be adequately prepared for a crisis, warned Viral Acharya, a professor of economics at New York University.<\/p>\n Lorie Logan, who oversaw balance sheet operations at the Federal Reserve Bank of New York before becoming a regional president in Dallas, has also proposed<\/a> making the central bank\u2019s lending facilities more accessible. That would encourage banks to hold fewer reserves while also giving them confidence that they have access to cash if need be. This would require reducing negative connotations that have often plagued these facilities, especially the discount window. The fear for lenders has long been that tapping it sends a signal that they are on shaky footing.<\/p>\n One of the easiest ways to mitigate any potential cash crunch during the transition period would be for the Fed to stand ready to intervene when necessary in the form of so-called temporary open market operations.<\/p>\n \u201cYou don\u2019t want to create any environment that would increase liquidity pressure on the system,\u201d said Patricia Zobel, who ran the group that executed monetary policy at the New York Fed before joining Guggenheim Investments.<\/p>\n A more aggressive \u2014 and likely contentious \u2014 lever to pull<\/a> is for the Fed to pay banks a lower rate on their reserve balances beyond a certain level. That would sharply reduce the incentive for banks to hold extra cash, but it would likely be difficult to structure and face intense pushback from the industry. It could also potentially undermine the Fed\u2019s ability to control rates.<\/p>\n