Can Kevin Warsh Tame the Fed’s $6.7 Trillion Balance Sheet?

Kevin Warsh has a long to-do list for the Federal Reserve. There’s the Federal Open Market Committee (FOMC)’s dual mandate of promoting maximum employment and stable prices, which requires a balancing act by Warsh and his fellow committee members. He also wants to narrow the Fed’s focus, rethink post-meeting press conferences and forward-looking guidance (Warsh has essentially said his colleagues talk too much) and potentially change how the central bank measures inflation. But one of the biggest challenges of Warsh’s chairmanship will be following up on his pre-confirmation goal to shrink the Bigfoot-sized footprint the Fed has on the financial markets. Reducing its $6.7 trillion balance sheet won’t be easy. Warsh’s Take Critics of the Fed’s market intervention like Warsh say that since the Global Financial Crisis, the central bank has manipulated specific pockets of the economy by buying Treasurys and mortgage-backed securities, controlling the yield curve, lending to banks, intervening in credit markets and more. “The reality is the tradeoff has been an unintended spillover with far-reaching implications,” said Jeff Klingelhofer, managing director and portfolio manager at Aristotle. Let’s rewind to 2008. Before the height of the financial crisis, the balance sheet was roughly $900 billion. But as the Fed purchased large amounts of US Treasurys and mortgage-backed securities to help stabilize the economy, it swelled to $4 trillion by 2014. (The securities purchases essentially injected liquidity into the market, attempting to encourage banks to lend and companies to grow when neither were doing so.) The central bank then kept the balance sheet somewhat steady until starting to shrink it in 2018 (as criticism from Congress grew) by letting maturing assets roll off without reinvesting the principal. Then, COVID-19 hit. In an effort to prevent an economic collapse, the Fed returned to buying and the balance sheet roughly doubled in size. It wasn’t until 2022 that the central bank, under former Fed Chair Jerome Powell, was able to resume trimming, bringing the balance sheet from nearly $9 trillion to the current $6.7 trillion. Warsh has suggested that the Fed’s massive portfolio of government bonds and mortgage-backed securities poses a threat to the central bank’s independence, since it gives the Fed more sway over more areas of the financial markets, heightening opportunities for political influence. Plus, Wall Street potentially expecting the Fed to be a knight in shining armor, riding to the rescue when the economy starts to sour, doesn’t exactly spell independent monetary policy. But the new Fed chair has also indicated that a smaller balance sheet would allow the Fed to cut interest rates — something the financial markets (and President Donald Trump) would like. David Wessel, senior fellow in Economic Studies at Brookings and director of the Hutchins Center on Fiscal and Monetary Policy, explains that if you increase the balance sheet, that’s believed to stimulate the economy. If you reduce the balance sheet, that would, using the same logic, restrain the economy. In that scenario, bringing down inflation would allow the Fed to lower interest rates. “What he’s really talking about would result in a steeper yield curve, lower short-term rates and higher longer-term rates,” Wessel said. The Fed buying fewer bonds typically pushes long-term rates up, while rate cuts bring short-term rates down; the difference between the two, illustrated on a graph, is known as the yield curve. The risk of that strategy is that higher long-term rates could make mortgage rates, already steep enough to keep some buyers out of the housing market, increase. “I find it hard to believe that Donald Trump and [Treasury Secretary] Scott Bessent are really in favor of Fed maneuvers that would lead to higher mortgage rates. I don’t know that they’ve thought this through.” Can He Do It? Of course, what Warsh actually does is more important than what he said he would do when he was campaigning to lead the Fed. In the past, the Fed has shrunk its balance sheet by letting long-term bonds expire without purchasing more. During Warsh’s confirmation hearing, he assured lawmakers that working toward his balance sheet objectives would be a slow process: Wessel expects that would start with Warsh initiating a study, perhaps via a subcommittee of the FOMC. “The issue is if you’re going to shrink the Fed’s assets, you have to shrink their liabilities,” Wessel said. Some experts argue that one way to accomplish that is lowering the amount of reserves that banks hold at the Fed. There are four ways the Fed might do so, Darrell Duffie, an economist and professor at the Stanford Graduate School of Business, said in a research paper in March. It could change banks’ liquidity regulations so that they feel less pressure to hold reserves, or it could change its payment system so banks could make outgoing payments with incoming ones, which would require them to have fewer reserves at the beginning of each day. Other options are to offer lower interest rates on reserve balances beyond a certain threshold, pushing banks to lend more, or to “smooth the path of reserves by offsetting unintended shocks to the supply of reserve balances, such as those that occur at the end of each quarter.” Wessel said that while we know Warsh’s preferences, “the notion that somehow, six months from now, [the balance sheet] is going to be $1 trillion smaller is ridiculous.” What Change Means for Markets The balance sheet has become somewhat symbolic of the Fed’s interventions in the financial markets. Warsh is likely instead to use a back-to-the-basics approach focused on interest rates and their intersection with the US economy while recognizing and accepting the bluntness of that tool, Klingelhofer said. Markets need to prepare for the impact of that strategy. “We have to remind ourselves this is healthy, as every economy needs a business cycle in order to prosper,” Klingelhofer added. “The goal of this Fed is likely to be closer to allowing a business cycle to play out while cushioning against potential extremes, which is quite different from how I would characterize the last few Feds’ search to engineer a specific business-cycle outcome.”