The Federal Reserve should avoid any move to significantly shrink its balance sheet, two prominent economists warned Tuesday — arguing against a strategy that the US central bank's
"There may be changes that would pass a cost-benefit test that would shrink the Fed's balance sheet somewhat," Christina Romer and David Romer of the University of California, Berkeley, wrote in a report released by a unit of the Brookings Institution. However, they added, "there would be substantial downsides and no significant upsides to attempts to shrink its size greatly."
Kevin Warsh, who began his four-year term at the Fed's helm little more than a week ago, has long called for a smaller Fed footprint in the financial system, after its balance sheet surged during the global financial crisis and again during the Covid-19 pandemic. In his Senate confirmation hearing in April, Warsh reiterated his call for a smaller balance sheet, while saying any move to implement that would need to be deliberate and "well-orchestrated."
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The Romers' caution was one of the lessons the economists drew from a lookback at former Chair Jerome Powell's two terms running the Fed. Titled "An Early Retrospective on Monetary Policy in the Powell Era," it was published by the Hutchins Center on Fiscal and Monetary Policy. Christina Romer served as chair of the Council of Economic Advisers in the Obama administration.
Warsh has argued that a smaller balance sheet would allow scope for lower interest rates and would allow for stricter lines between monetary and fiscal policy. The current $6.7 trillion total, featuring almost $4.5 trillion of Treasuries and nearly $2 trillion of mortgage securities, reflects an increased Fed "imprimatur" on the economy, he said in April.
Powell and his colleagues called off a previous effort to run down the balance sheet in 2019, after it ended up roiling money markets. Last year, the Fed ended its second so-called quantitative tightening initiative in the aim of ensuring an ample amount of reserves in the financial system and avoiding any repeat of what happened on that prior occasion.
A clear lesson, the Romers wrote, is that the central bank's balance sheet should remain large. Any attempt to return to a regime of "scarce reserves" would trigger much greater interest-rate volatility, they said.
"One aspect of the Fed's current balance sheet, however, seems harder to justify: its large holdings of mortgage-backed securities," the authors wrote. These involve favoring one particular sector of credit, they indicated.
Dumping Mortgages
The Fed has been shrinking its MBS pile, but the pace since 2024 would leave it taking over a decade to run it down, the Romers said. Getting the Fed out of "sectoral credit allocation points to increasing that pace," they said.
In other findings, the Brookings report said that the Fed needs to move fast when conditions change and that inflation hurts the economy even if inflation expectations remain anchored.
The report also cautioned the Fed needs to carefully use so-called forward guidance, where it guides investors on the future path for monetary policy.
"Because it always runs a risk of influencing future decisions in undesirable ways that were not anticipated, the bar for using it should be high," the authors wrote. "And second, it should be crafted with a wide range of possible paths for the economy in mind, not just the most likely ones."
The Romers credited former Fed Chairs Ben Bernanke and Janet Yellen, among others, for comments and suggestions on their assessment.
