Fed's Barr warns of tradeoffs in shrinking balance sheet

• Key takeaway: Federal Reserve Gov. Michael Barr said shrinking the central bank's balance sheet could have unintended consequences, including increasing the Fed's footprint in financial markets. 
• Expert quote: "I think shrinking the balance sheet is the wrong objective, and many of the proposals to meet this objective would undermine bank resilience, impede money market functioning and, ultimately, threaten financial stability." — Federal Reserve Gov. Michael Barr
• What's at stake: Kevin Warsh, the incoming Federal Reserve chair, has said shrinking the central bank's balance sheet will be a priority.

Federal Reserve Gov. Michael Barr warned Thursday against efforts to shrink the central bank's balance sheet, saying such moves could undermine financial stability and ultimately make the Fed more active in financial markets rather than less.

Speaking at a Money Marketeers event in New York, Barr outlined several recently floated proposals to reduce the Fed's balance sheet, including lowering reserve demand, easing regulatory thresholds for banks or having the Treasury reduce the size of its account at the Fed. He said some of those ideas could carry unintended consequences, including increasing the Fed's footprint in financial markets.

"I think shrinking the balance sheet is the wrong objective, and many of the proposals to meet this objective would undermine bank resilience, impede money market functioning and, ultimately, threaten financial stability," Barr said. "Some would actually increase the Fed's footprint in financial markets."

Barr said reserve requirements are "essential to the safety and soundness of our banking system" and warned that reducing reserves too far could put a strain on the payments system.

"It gives banks an incentive to economize on their liquidity by slowing down their outgoing payments, leading to bottlenecks and stresses in funding markets," he said. "And, as we know, during stress, if banks do not have enough reserves when depositors ask for withdrawals, panic can ensue."

Barr also warned that operating with lower reserve levels could increase market volatility and raise the risk that the Fed loses control of short-term interest rates.

"That's what we saw in 2019 when repo market rates spiked," Barr said. "The Fed avoided this outcome in late 2025 by acting in advance to incrementally grow our balance sheet."

He said lower reserves could make financial markets more fragile and require the Fed to intervene more frequently through lending facilities such as the standing repo facility or the discount window. He added that such a system would depend on banks being more willing to use those tools.

"If banks overcame their reluctance to use standing repo operations and the discount window, rate control could be maintained with a lower level of reserves," he said. "But it would mean that the Fed would be lending into the market on a regular basis, again, a form of a bigger footprint. I'm not opposed to Fed lending, but it would not reduce the Fed's footprint in the market."

Barr also questioned the rationale for shrinking the Fed's balance sheet if doing so reduced financial resilience.

"In sum, shrinking the Fed's balance sheet is the wrong goal, and reducing the resilience of the banking system is the wrong means," he said.

Barr's comments com in stark contrast to those of incoming Fed chair Kevin Warsh, who has argued for reducing the size of the central bank's balance sheet. Less than $1 trillion before the 2008 financial crisis, the Fed's balance sheet swelled to nearly $9 trillion at its peak during the pandemic, when it purchased large quantities of Treasury securities and mortgage-backed securities to support the economy. It has since fallen to about $6.7 trillion, but remains well above pre-crisis levels.

Warsh has long criticized that expansion. In a Wall Street Journal op-ed last year, he wrote: "The Fed's bloated balance sheet, designed to support the biggest firms in a bygone crisis era, can be reduced significantly." He added that "largesse can be redeployed in the form of lower interest rates to support households and small and medium-size businesses."