Trump nominee Kevin Warsh confronts structural limits on shrinking the Fed’s US$6.7 trillion balance sheet
Kevin Warsh wants a much smaller US Federal Reserve balance sheet.
The system he would inherit may not let him get there – and that constraint now sits alongside a live debate over whether the Fed’s next move is a cut, a prolonged pause, or even a hike.
According to Reuters, Warsh, nominated by the Trump administration to replace Jerome Powell when his term ends in May, has long argued that large Fed holdings distort markets and favour Wall Street over Main Street.
He has pushed for further balance sheet contraction, arguing that pushing liquidity out of the Fed and into the US broader economy could support a lower policy rate than otherwise.
The problem is structural.
As Reuters reported, the Fed’s current operating framework depends on banks holding large reserves, backed by a sizeable portfolio of Treasuries and mortgage bonds.
After crisis-era and pandemic-era asset purchases, Fed holdings peaked at roughly US$9tn in spring 2022 and never returned close to pre-crisis levels in earlier attempts to shrink the balance sheet.
To keep its rate target on track, the Fed now relies on “largely automatic” tools, formalised in 2019, that allow it to absorb or inject cash and provide liquidity quickly.
The latest round of quantitative tightening (QT), launched in 2022, tried to drain excess liquidity.
According to Reuters, officials said QT would end once liquidity fell to a point that still allowed firm control of the US federal funds rate. That line was reached late last year when money market rates started to climb and some firms had to borrow directly from the Fed to meet liquidity needs.
Ending QT calmed markets and trimmed total holdings from about US$9tn to around US$6.7tn, but the Fed is now rebuilding its holdings into the spring as a technical step to manage money market rates.
Analysts warn that pushing much further could be risky without regulatory change.
BMO Capital Markets argued that “there isn't a straightforward path to a smaller Fed footprint in financial markets.”
It added that “much smaller [System Open Market Account] holdings may not be feasible unless there are regulatory reforms that reduce banks’ demand for reserves,” a process it expects will “take quarters, not months, to unfold.”
Economists Stephen Cecchetti and Kermit Schoenholtz wrote that a large balance sheet “facilitates government financing that is highly undesirable” and interferes with markets.
They also warned that, under current rules, “shrinking the balance sheet significantly would expose short-term markets to substantial volatility risk – a cure potentially worse than the disease,” as reported by Reuters.
Some on the Street see scope for tinkering but not another full-blown QT push.
Morgan Stanley said rule changes could reduce banks’ appetite for liquidity, but “lower liquidity buffers could increase financial stability risks.”
JP Morgan economists Jay Barry and Michael Feroli told clients that stronger Fed repo facilities might give banks confidence to hold less cash, but still concluded “we do not think it is likely the Fed can restart QT.”
Evercore ISI went further, saying they “think he will not push for a return” to the pre-crisis framework and that a return to QT is “off the table” because it would signal reluctance to use the balance sheet as a tool in future and push bond borrowing costs higher now, as per Reuters.
At the same time, the January 27–28 Federal Open Market Committee (FOMC) minutes show a central bank more worried about upside inflation risk and less inclined to rush back into easing.
The Fed held the federal funds rate at 3.5 percent–3.75 percent after three straight 0.25 percentage point cuts, with two governors dissenting in favour of another cut, according to the Financial Times.
Jay Powell said after the meeting that it would “likely be appropriate to hold the policy rate steady for some time” as the committee assesses data, a stance the minutes echoed.
Most participants still expect inflation to drift toward the 2 percent target but warned that progress “might be slower and more uneven than generally expected” and that the risk of inflation running persistently above target remains “meaningful.”
The Fed’s preferred PCE measure ran at 2.8 percent year-over-year in November, and a separate consumer price index rose 2.4 percent in January.
The committee remains divided on what comes next.
CNBC reported that several participants said further cuts would likely be appropriate if inflation declines as expected, while “some” argued it would be appropriate to hold the US policy rate steady “for some time.”
A number of officials wanted the statement to present “a two-sided description” of future moves, explicitly including the possibility that “upward adjustments” to the rate range could be appropriate if inflation stays above target.
Bloomberg similarly noted that “several” policymakers backed language highlighting the chance of rate hikes and that a “vast majority” now see downside risks to employment as having moderated while the risk of more persistent inflation remains.
The labour backdrop gives the Fed more room to lean that way.
According to the Financial Times, officials agreed that labour market conditions “may be stabilising after a period of gradual cooling,” and a recent report showed the US economy adding 130,000 jobs in January, the strongest monthly gain in more than a year.
Bloomberg also reported a 130,000 payroll increase and a drop in the unemployment rate to 4.3 percent.
Markets, so far, have absorbed the more hawkish tone.
The two-year US Treasury yield edged up to 3.46 percent after the minutes, and futures pricing implies two to three cuts this year, with the next move most likely in June and another in September or October, according to the Financial Times.
Bloomberg reported that traders have dialled back expectations for near-term easing but still see a cut by mid-year.
