Newly appointed Federal Reserve chief Kevin Warsh faces immediate pushback against his ambitious plan to reduce the central bank's $6.7 trillion balance sheet. The Fed's asset portfolio, which ballooned from $800 billion before the 2008 financial crisis to nearly $9 trillion in 2022, has been a cornerstone of the bank's crisis management strategy. However, Warsh argues that this tool has been overused for monetary stimulus outside of emergencies, benefiting financial asset holders disproportionately.
The Risks of Rapid Reduction
Reducing the Fed's holdings could lead to higher mortgage rates and longer-term borrowing costs. Moreover, without first reducing the demand for reserves in the banking system, such actions could destabilize money markets. Former Chicago Fed president Charles Evans expressed skepticism about proposals to curb banks' demand for reserves, describing them as 'ambitious, substantial, Manhattan Project-like initiatives.'
'It took us 18 years to create this big balance sheet that's done quite a bit of harm,' Warsh noted during his confirmation hearing, emphasizing the need to move 'slowly and deliberately.'
Internal Opposition
Warsh's agenda faces opposition within the Fed. Governor Michael Barr recently stated that shrinking the balance sheet is 'the wrong objective,' warning that such moves could undermine bank resilience, impede money market functioning, and threaten financial stability.
Potential Alternatives
Roberto Perli, who oversees the Fed's markets operations at the New York Fed, suggested that a smaller balance sheet could be achievable if banks' demand for reserves diminishes through regulatory changes. However, he cautioned that draining too much cash from the banking system could have rapid, adverse consequences.