Federal Reserve Chair nominee Kevin Warsh has several paths toward reducing the central bank's $6.6 trillion balance sheet but the process will be costly and lengthy, Wall Street strategists say.
Warsh has called for dramatically paring the Fed's massive financial footprint, rekindling the debate around the size of its portfolio which swelled after successive rounds of crisis-driven asset purchases. Minutes from the January policy meeting due Wednesday are likely to offer insights on policymakers' latest thinking on the balance sheet.
Kansas City Fed President Jeff Schmid said last week that a large portfolio risks
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Options range from easing regulations that encourage banks to hold large cash reserves with the central bank, to shortening the average maturity of the Fed's holdings, strategists say. The Fed could also stop buying Treasury bills or even sell securities outright.
A less likely path would be to resume unwinding holdings, a process knowing as quantitative tightening, which the central bank abandoned in December after an increase in government borrowing fueled money markets strains. In turn, the Fed pivoted to buying T-bills in a bid to add reserves back into the system.
Whatever path a Warsh-led Fed takes, it's likely to take years. "I think of this as a 2027 phenomenon at the earliest," said Seth Carpenter, global chief economist at Morgan Stanley, and a former deputy director at the Fed's monetary affairs division.
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It will also have to be in agreement with Treasury secretary Scott Bessent, Jonathan Cohn, head of US rates desk strategy at Nomura Securities International Inc, said.
"The idea of the Fed just all of a sudden pushing out a whole bunch of Treasury supply onto private investors, and the term premium impact that might have — that would be a wild own goal for that duo to commit," Cohn said.
Here are some of Warsh's options cited by Wall Street:
End bill purchases
While restarting QT is unlikely, the Fed could gradually reduce the pace of T-bill purchases from $40 billion a month currently, or stop them altogether, according to Citigroup Inc. strategists Alejandra Vazquez Plata and Jason Williams. Their analysis
The challenge with such a plan is that it puts the central bank's policy of holding "ample reserves" in jeopardy, according to Barclays Plc analysts. Adopted in the decades after the 2008 financial crisis, the policy is designed to keep enough cash flowing through the banking system so that lenders can meet regulatory and settlement needs.
"A return to an environment where reserves are scarce could result in banks' overdrawing their accounts, and in turn increased borrowing and gyrations in the size of the Fed's balance sheet," strategists Anshul Pradhan, Samuel Earl and Demi Hu wrote.
Change regulation
For strategists at Deutsche Bank and JPMorgan Chase & Co. easing regulation will help reduce banks' demand for reserves — one of the Fed's biggest liabilities. Regulators could relax the liquidity coverage ratio or internal liquidity stress test requirements so lenders need to hold less cash. Dallas Fed President Lorie Logan, who previously managed the central bank's asset portfolio at the New York Fed, has acknowledged
However, regulatory changes take time. Bowman is currently focused on other reforms,
Shift asset mix
The Fed can shorten the duration of its portfolio by continuing T-bills purchases or rolling mortgage-related holdings into short-dated debt to more closely match Treasury's issuance profile. The central bank holds about $1.9 trillion Treasury notes that are maturing between 2026 and 2030. If it opted to reinvest half of those into T-bills, the average maturity of its assets would converge with Treasury's around mid-2029, JPMorgan's Feroli and Barry wrote.
Such a move would realign the Fed with pre-crisis averages and give it more easing power over time, allowing it to "twist" its purchases toward long-term debt when needed.
But without close coordination with Treasury, long-dated debt issuance needs and costs would rise significantly as the Fed retreats. Warsh has voiced support for overhauling the relationship between the Fed and Treasury with a new version of an agreement struck in 1951.
Barclays estimates that over a five-year period the market would have to absorb almost $1.7 trillion more in 10-year equivalent debt, pushing borrowing costs up by 40 to 50 basis points. The share of short-term debt held by the private sector would also fall, potentially distorting the bill market.
Sell assets
Policymakers have discussed sales of assets, particularly mortgage-backed securities, though these would result in losses for the Fed. Morgan Stanley economists led by Michael Gapen estimate that outright sales of agency MBS would likely more than double the Fed's current operating losses. But the central bank's profitability would increase over time since it wouldn't be collecting interest below the rate it pays.
"In other words, a deeper hole to climb out of, but perhaps it could climb out at a faster pace," they wrote.
