Kevin Warsh’s ambition to significantly reduce the Federal Reserve’s multi-trillion-dollar balance sheet may encounter substantial obstacles, according to financial experts. The complexities of unwinding the Fed’s holdings while maintaining market stability and achieving monetary policy goals present a considerable challenge. Experts believe any notable contraction of central bank bond holdings could inadvertently tighten financial conditions.
Warsh, a former Fed governor, has voiced concerns about the distorting effects of the Fed’s large holdings on the economy and advocated for a reduction. He suggested redeploying the proceeds to lower interest rates for households and small to medium-sized businesses. This stance comes as the Fed recently concluded a three-year effort to reduce bond holdings acquired during the COVID-19 pandemic, where aggressive purchases aimed to stabilise markets and stimulate the economy.
However, decreasing the balance sheet could prove difficult without risking market volatility. Banks require a certain level of reserves to maintain stability, and reducing reserves too far could trigger volatility in money market rates, hindering the Fed’s ability to manage its interest rate target. SMBC Capital Markets, Inc. notes that banks want a certain level of reserves to maintain stability.
Analysts suggest that easing regulatory burdens on banks’ liquidity management and enhancing the attractiveness of Fed liquidity facilities could help reduce the demand for reserves, allowing for a smaller Fed footprint over time. Evercore ISI analysts suggest any balance sheet moves would be slow and mindful of the financial risks. Overall, any significant shift would require consensus among Fed policymakers, who have largely supported using the balance sheet as a policy tool.
