- Key insight: For the Federal Reserve to shrink its balance sheet, it will need banks to hold fewer deposits at the central bank. Achieving that reduction starts with regulatory reform, analysts and academics say.
- Expert quote: "The way to get this accomplished is alongside a changing liquidity, regulatory and supervisory backdrop for the Fed." — Jay Barry, head of global rates strategy, JPMorgan Chase
- Forward Look: The Fed's task force on balance sheet policy convened earlier this month and is expected to deliver recommendations by the end of the year.
As the Federal Reserve rethinks its balance sheet, all eyes are on the liability side of its books.
Shrinking the Fed's balance sheet has been a fixation for Fed Chair Kevin Warsh since the end of his first stint on the Board of Governors in 2011. Earlier this month, he commissioned a
In anticipation of this, academics and analysts have spent the past several months exploring the possible routes the Fed could take to reduce its holdings. Opinions are mixed as to whether the central bank needs a smaller balance sheet, but a common conclusion is that before the Fed can shed assets, it needs to address its liabilities.
"The Fed could run a very large balance sheet … and then you wouldn't need to think about it," said Darrell Duffie, an economist and professor at Stanford University's Graduate School of Business, during a recent presentation at the Federal Reserve Bank of New York. "If the balance sheet task force that Chair Warsh has empaneled says, 'No, we really want to reduce the balance sheet,' then you're going to need options, because it's as small as it can get in the current operating framework. [You] can't make it any smaller without changing something."
Duffie is the author of one of three academic papers published this year taking aim at the topic of the Fed's balance sheet. Another was co-authored by Federal Reserve Bank of Dallas President Lorie Logan and a third was compiled by economists and researchers for the Federal Reserve Board.
The studies delve into the various Fed functions that shape the demand for liabilities on its balance sheet, including market-making activities, payments processing, and regulation and supervision. While asset purchases drove the Fed's balance sheet from less than $1 trillion in 2010 to $9 trillion at the height of the COVID-19 pandemic, Logan, in an
"The minimum size of the Fed's balance sheet is determined by demand for our liabilities, such as currency and bank reserves," Logan said. "We can always offer more liquidity than the economy demands, but if we don't meet the demand, financial pressures result."
Ample, scarce or something else
With more than $3 trillion in the system, reserves are the biggest category of liabilities on the Fed's $6.7 trillion balance sheet and the only one it has direct control over via its interest on reserve balances and open market trading activities. The next two biggest liabilities are currency in circulation ($2.4 trillion) and the Treasury's general account (roughly $700 billion).
Since 2019, the Fed has pursued an "ample reserves regime," meaning it seeks to maintain more reserves than banks need to manage their liquidity needs and settle transactions with one another. In his prepared testimony to Congress last week, Warsh said he has instructed his task force to explore the "advantages and disadvantages of that regime" as well as potential alternatives.
Warsh has a long track record of being skeptical of large-scale asset purchases at the Fed. As a member of the Board of Governors in 2010, he was reluctant to support balance sheet expansion, known as quantitative easing, arguing it would disproportionately benefit the financial sector, provide little boost to the "real economy" and spur inflation. He continued to criticize the Fed's policies in similar terms for years, calling the balance sheet "bloated" and saying it played an outsized role in the U.S. economy.
Since
"My predelection, my inclination is interest rate policy should be the driver of monetary policy," Warsh
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His balance sheet task force includes former Fed Gov. Jeremy Stein, former Governor of the Reserve Bank of India Raghuram Rajan and Karen Dynan, an economics professor at Harvard. Their policy recommendations to the Federal Open Market Committee are expected by the end of the year. Stein, Rajan and Dynan declined to discuss the parameters of the review this week.
The most dramatic option available to the central bank for balance sheet reduction is a return to a "scarce reserves" regime, one in which the volume of reserves is small and actively managed by the Fed's open market desk in New York. The Fed employed this approach until 2008, when it began
Logan, a former head of the Fed's System Open Market Account, said that system disincentivized banks from maintaining sufficient liquidity.
"Market rates were typically hundreds of basis points above zero," she said. "The spread made it costly for banks to hold reserves, so they tried to economize — hence the name 'scarce.'"
Warsh has said he does not expect to revert to the Fed's pre-financial crisis reserve management approach, but he believes the current framework is not the central bank's only viable option.
"I'm not of the mistaken view that we can go back to where we were when I arrived at the Fed in 2006, but I think there are several other sustainable equilibria we can achieve," he said.
Reform by regulation
Instead of returning to scarcity, Logan said one of her preferred solutions is to reduce the demand for reserves by doing away with regulations that cause banks to hoard them in good times and bad.
"Regulations like that might boost reserve holdings without necessarily making the financial system safer," Logan said. "That's an inefficient use of the Fed's balance sheet, and one we could do without."
It's a concept embraced by industry participants and analysts as well.
"The balance sheet — if you do it the right way, you could see it decline in size by $600 to $700 billion from current size," Jay Barry, head of global rates strategy for JPMorgan, said during a webinar on Monday. "The way to get this accomplished is alongside a changing liquidity, regulatory and supervisory backdrop for the Fed."
A reduction in that range would make the balance sheet about 10% smaller than it is today, returning it to a size last seen in the spring of 2020, as the Fed was rapidly expanding its holdings to bolster a pandemic-addled U.S. economy.
Barry estimates that increasing the Fed's balance sheet as a share of gross domestic product by 1 percentage point reduces 10-year Treasury yields by 10 basis points and reduces the difference between the 10-year and 2-year yields by 5 basis points. By his math, a $600 billion to $700 billion reduction in the balance sheet would increase long-term rates by between 15 and 20 basis points while steepening the yield curve by 5 to 10 basis points — changes that could be a boon to net interest margins for banks.
The Fed and the Treasury Department are already exploring options for changing the liquidity coverage ratio and other policies to disincentivize reserve hoarding by banks. Earlier this year, the Fed solicited feedback from banks about reforms they'd like to see related to liquidity rules and emergency lending facilities.
Fed Vice Chair for Supervision Michelle Bowman,
"I would like to see a smaller balance sheet for the Federal Reserve as a whole," Bowman said. "A lot of approaches to liquidity really don't incentivize a smaller balance sheet."
Banks have called for liquidity relief for years, but the different regulatory treatment alone might not be enough to convince them from relinquishing their stockpile of reserves.
Mark Cabana, head of U.S. rates strategy and Bank of America Global Research, said any regulatory reform should be matched with supervisory changes to ensure banks will not be penalized for using the discount window or other Fed lending facilities.
Cabana added that the "single most impactful" change the Fed could make related to the discount window is ending the weekly reporting of reserve distribution across the 12 Fed reserve districts. He noted that large changes in those figures can be used to identify banks that borrow from the central bank — a fact that he said contributes to the reluctance of banks to use those facilities.
"Ending that reporting is not novel, but the Fed hasn't done it," he said. "The second most impactful thing it could do is change the supervisory framework and how it scores banks for accessing the Fed's liquidity facilities. The stigma around using those facilities runs very deep."
Payments and repo
While most of the attention has centered on reserve demand, recent research suggests it is not the only — or even the most pressing — liability dynamic for the task force to consider.
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The Fed launched the ON RRP in 2013 to put a floor under short-term interest rates as means of lifting the federal funds rate above the zero lower bound, where it had been since the onset of the financial crisis. Through this facility, the Fed sells Treasury securities to money market funds overnight with an agreement to buy them back the next day at a premium. Funds use the facility when they have a surplus of cash that they cannot use for standard repurchase agreement lending, known as repo lending.
The Fed study finds that as the quantitative tightening plays out — meaning securities mature without being replaced on the central bank's balance sheet — it does more than just eliminate reserves. When the Fed pulls back from Treasury purchases more securities are sold to other market participants, increasing demand for repo borrowing. When the Fed's balance sheet is large enough to support ON RRP usage, money market funds can easily accommodate this demand, but when the ON RRP falls to zero, liquidity becomes scarce and repo rates increase.
While policymakers and academics have acknowledged the ON RRP's role as a buffer against scarcity, the paper states that most literature on the Fed's balance sheet overlooks the importance of repo market making in the transmission of monetary policy.
"This finding has important policy implications," the researchers write. "The Fed's minimum balance sheet size depends on policymakers' tolerance for repo market volatility, which can spill over to the federal funds market. More broadly, our framework suggests that focusing exclusively on reserve levels may lead to balance sheet reductions that go too far and compromise interest rate control."
The repo market isn't the only thing creating an unofficial floor beneath the Fed's balance sheet. Duffie, in his paper, makes the case that the Fed's payment system plays a similar role, albeit one that is also influenced by regulation and supervision.
Duffie notes that one reason banks hold on to such large sums of reserves is to ensure they do not overdraw their accounts when settling payments with each other. One option to address this, he said, is assuring banks they will not be penalized for temporary overdrafts. But if the Fed wanted to go beyond that, it could implement mechanical changes to its payment system that would reduce the amount of reserves needed on a day-to-day basis.
Duffie calls for the Fed to implement a liquidity savings mechanism, or LSM, in its Fedwire payments system that would automatically offset matching payments between banks. This means if one bank was set to send $100 million to another bank and receive $100 million from that same bank for different transactions, no reserves would change hands. He noted that other central banks have had success reducing their reserve needs through similar mechanisms.
"The Bank of England has achieved a 20-30% reduction in the amount of reserve balances needed to run its payment system by virtue of having an LSM in their large value payment system," Duffie said at the New York Fed.
'More bark than bite'?
While each of these reforms could chip away at the size of the Fed's balance sheet, it is not clear that any of them would effectuate a radical reduction in the size of the Fed's holdings.
Where the Fed ultimately takes its balance sheet policy will depend on the task force's findings and the prerogatives of not only Warsh but the FOMC as a whole.
For now, banks are confident that their strong preference for ample reserves and the potential disruption that would come from a speedy unwind of the current system mean that the status quo is likely to prevail for the foreseeable future.
"Our overall view on Warsh on the balance sheet is he's more bark than bite," Cabana said. "We don't think he will be able to materially reduce the size of the Fed's balance sheet because there is a lot of demand for reserves. If the Fed wants to do anything with regards to its balance sheet size, it needs to try to reduce the demand for reserves."
Warsh acknowledged as much during his testimony last week before the House Financial Services Committee last week, saying that whatever route the Fed takes, the FOMC will be transparent and deliberate in its actions to ensure markets are informed every step of the way.
"It took us nearly 18 years to find our way into this balance sheet," Warsh said. "We're holding a lot of long-term Treasury debt, long-term mortgage-backed securities. We won't be able to make changes overnight."
