Warsh may want a smaller Fed balance sheet, but that's hard to achieve

• The Fed's balance sheet peaked at $9 trillion in spring 2022 and has been reduced to $6.7 trillion, but further contraction (quantitative tightening) was halted in 2024 when money markets became unstable
• Analysts say shrinking the balance sheet further would require regulatory reforms to reduce banks' demand for reserves, a process taking 'quarters, not months,' and could increase financial stability risks
• Most Fed watchers believe Warsh will be constrained by financial realities, with analysts stating a return to pre-crisis policy tools or renewed quantitative tightening is unlikely as it would raise bond market borrowing costs

Market Summary: Warsh Fed Nomination and Balance Sheet Challenges

Key Development:

Kevin Warsh, nominated to lead the Federal Reserve and succeed Jerome Powell in May, faces significant obstacles in achieving his goal of shrinking the Fed's balance sheet, currently at $6.7 trillion.

Main Points:

Warsh, a former Fed Governor (2006-2011) and Stanford visiting fellow, has been a long-time critic of large Fed holdings. However, experts warn that substantial contraction is technically difficult and potentially destabilizing under current monetary policy frameworks.

The Fed's balance sheet peaked at $9 trillion in spring 2022 following aggressive bond purchases during the financial crisis and COVID-19 pandemic. Through quantitative tightening (QT) that began in 2022, holdings were reduced to $6.7 trillion before money market volatility forced a halt in recent periods. QT has been suspended into spring as a technical measure.

Technical Challenges:

The current system requires banks to hold large reserve amounts for the Fed to control interest rates effectively. Further contraction could cause loss of control over the federal funds rate and increase short-term market volatility.

Possible Solutions:

Analysts suggest regulatory reforms to reduce banks' reserve demand could provide space for balance sheet reduction, though this would take "quarters, not months." Options include:

• Modifying liquidity regulations
• Enhancing Fed repo operations to boost bank confidence
• Tighter Treasury-Fed coordination

However, Morgan Stanley warns lower liquidity buffers "could increase financial stability risks."

Market Implications:

Most Fed watchers expect financial realities will moderate Warsh's ambitions. Analysts at Evercore ISI and J.P. Morgan doubt QT will restart, as signaling reluctance to use the balance sheet would raise bond market borrowing costs immediately.