US Market | Kevin Warsh’s push for a smaller Fed balance sheet faces structural hurdles

Kevin Warsh, nominated to lead the Federal Reserve, is expected to favor reducing the central bank’s balance sheet. However, according to a Reuters analysis, achieving a materially smaller footprint may prove difficult without significant changes to financial system rules—and even then, the outcome is uncertain.

The current framework the Fed uses to implement monetary policy relies heavily on banks holding substantial reserves. This abundant liquidity helps the central bank maintain control over short-term interest rates and ensures stability in money markets. This structure inherently limits how far the Fed can shrink its asset holdings without risking disruptions.

Market experts broadly agree that meaningful balance sheet reduction would likely require adjustments to how the Fed manages money market rates as well as regulatory reforms that influence banks’ demand for reserves. Without such changes, attempts to contract holdings too aggressively could introduce volatility into short-term funding markets.

Longstanding Skepticism Towards Fed Asset Purchases

Warsh, who previously served as a Fed governor from 2006 to 2011, has long been critical of the central bank’s reliance on large-scale asset purchases.

Since the global financial crisis and again during the COVID-19 pandemic, the Fed has expanded its balance sheet through large purchases of Treasury and mortgage securities to stabilize markets and support the economy when interest rates approached zero. These programs pushed total holdings to roughly $9 trillion at their peak in 2022. Even after periods of balance sheet reduction, assets have remained far above pre-crisis levels.

The Fed’s operating framework, formalized in recent years, uses standing facilities and other tools to absorb or supply liquidity as needed, allowing policymakers to keep the federal funds rate within target ranges. This system has reinforced the need for ample reserves across the banking sector.

Quantitative Tightening and Its Limits

Reuters highlighted that Warsh renewed his criticism last year as the Fed carried out quantitative tightening, a process launched in 2022 to gradually reduce asset holdings and drain excess liquidity. The effort slowed and eventually ended as funding pressures emerged and some market rates began to climb, signaling that liquidity was approaching minimum comfortable levels.

Since then, the Fed has reduced its balance sheet to about $6.7 trillion and has taken technical steps to stabilize money markets, including modest increases in holdings.

Debate Over Rule Changes

Warsh has argued that a large balance sheet distorts financial markets and disproportionately benefits large financial institutions. He believes that reducing the Fed’s footprint could allow liquidity to flow more broadly through the economy and potentially enable lower policy rates.

Yet analysts caution that any significant reduction must contend with banks’ ongoing need for reserves. If liquidity falls too far, the Fed could lose precise control over short-term rates, complicating its efforts to meet inflation and employment objectives.

Some economists suggest that regulatory changes lowering liquidity requirements or adjustments to repo facilities could encourage banks to operate with smaller cash buffers, though these steps might introduce new financial stability risks. Others point to closer coordination between the Treasury and the Fed as a possible way to create room for a smaller balance sheet.

Expectations for a Pragmatic Approach

Despite Warsh’s criticisms, many analysts expect practical constraints to limit the scope of any overhaul. Experts widely believe financial realities will temper efforts to return to pre-crisis operating methods, when reserves were scarce and interest rate control relied on frequent market interventions.

A renewed push for aggressive balance sheet reduction is also viewed as unlikely, as it could signal to investors a diminished willingness to use asset purchases in future crises and potentially push borrowing costs higher.