By Howard Schneider
AMELIA ISLAND, Florida, May 18 (Reuters) – Veterans from the U.S. Federal Reserve’s past crisis-fighting efforts on Monday said incoming Chair Kevin Warsh should focus less on the central bank’s balance-sheet size and more on guidelines for how to use it in response to future financial and economic shocks.
The Fed’s $6.7 trillion balance sheet, much of it in holdings of U.S. Treasury and mortgage-backed securities, has been criticized by some lawmakers as a sign of Fed interference in financial markets. Warsh has cited it as a cause of past inflation and market distortion, and made reducing it a central part of promised “regime change” at the Fed.
But the current level is down about $2 trillion from its peak three years ago, and efforts to shrink it would mean less to the economy and markets than shifting the composition out of long-term securities and toward short-term bills that better match the balance sheet’s primary use of funding overnight bank reserves, said Harvard University economics professor Jeremy Stein, a Fed governor from 2012 to 2014 when it was in the midst of the “quantitative easing” bond-buying programs that increased the Fed’s asset holdings.
“The size of the balance sheet … has become a bit of an optical political football,” Stein told an Atlanta Fed financial markets conference on Monday. “Kevin has got himself a bit in the position of having to shrink that just to show some progress. It’ll be a test of his communication whether he can move the conversation away from that.”
Warsh has been confirmed by the U.S. Senate for a four-year term as chair, and now awaits a swearing-in expected to occur on Friday. As a Fed governor from 2006 to 2011, he backed QE’s initial use to support the economy in response to the 2007-to-2009 financial crisis and recession, with the Fed’s short-term rate already slashed to zero and purchases of longer-dated securities seen as a way to further hold down borrowing costs for businesses and consumers.
FROM CRISIS SUPPORTER TO BALANCE SHEET CRITIC
But he grew worried as the program continued and became effectively open-ended, felt it gave the Fed too large an imprint in financial markets, and renewed those criticisms after the Fed balance sheet ballooned again in response to the COVID-19 pandemic.
Reducing it, however, faces constraints, including that its size is driven by things not fully under the Fed’s control like bank demand for reserves. Policymakers have begun debating regulatory changes to lower reserve requirements, but how far that might go is uncertain.
Former Chicago Fed President Charles Evans, at the same event, noted that when he was appointed to his job in 2007, shortly after Warsh joined the Fed board, the Fed’s balance sheet was just about $800 billion.
SKEPTICISM OVER WARSH’S REDUCTION TARGETS
“Anyone longing for the good old days of $800 billion is just completely unrealistic,” Evans said, given the Fed’s balance sheet is now so closely tied to bank liquidity needs and is also the lever it uses to manage its short-term rate.
Warsh, Evans noted, had suggested in a 2025 Wall Street Journal article that the balance sheet could be drawn down by perhaps $2.5 trillion.
“I have my doubts,” Evans said, arguing that the regulatory and other proposals floated to allow a lower balance sheet are all “ambitious, substantial, Manhattan Project-like initiatives.”
The Fed’s balance sheet is now slowly growing again in response to bank reserve demands, which became evident last autumn when short-term rates rose, suggesting reserves were becoming scarce.
The broader issue for Warsh and the Fed going forward is setting principles around what it buys and why, and finding a way to communicate that to markets, elected officials and the public, said former Fed Governor Randall Kroszner, now an economics professor at the University of Chicago Booth School of Business.
Kroszner, an external member of the Bank of England’s Financial Policy Committee, said the BoE’s successful move in 2022 to quell a crisis in the UK government debt market depended on policymakers being clear that their bond purchases were meant only to keep markets functioning and would be short-lived.
For the Fed, lack of clarity about the aim of asset purchases has made the balance sheet more contentious, said Kroszner. During the COVID-19 pandemic, for example, asset purchases were restarted to keep the Treasury market functioning properly, evolved to include monetary policy aims of supporting the economy, and included mortgage-backed securities well after the housing market had stabilized.
The Fed “did exactly the right thing by intervening with incredible force to buy lots and lots of government securities,” Kroszner said. “But it then became very difficult to slow down … because it didn’t clearly articulate” what it was doing.
“It didn’t want to be perceived as pulling back on monetary policy … I think it’s much better to have things articulated in advance.”
(Reporting by Howard Schneider in Amelia Island, Florida;Editing by Dan Burns and Matthew Lewis)
