MNI INTERVIEW: Warsh Signals Caution On Balance Sheet Plans

Kevin Warsh's pledge at his confirmation hearing to shrink the Federal Reserve's balance sheet "slowly and deliberately" -- with advance notice to markets and in coordination with Treasury -- is an implicit acknowledgment of just how complicated and potentially risky the undertaking, Stephen Cecchetti, former Bank for International Settlements chief economist and New York Fed director of research, told MNI.

"That’s a healthy level of caution. Central banks are generally conservative institutions with good reason," Cecchetti said in an interview. 

Reducing the size of the Fed's USD6.7 trillion portfolio faces a set of structural obstacles more challenging than the political debate suggests. Warsh, who told senators Tuesday that the central bank's balance sheet has been "quite unhelpful" and amounts to "fiscal policy in disguise," will need to convince the rest of the FOMC that a smaller Fed footprint is worth the risk of financial instability, Cecchetti said.

"Almost everyone agrees that rate volatility on the overnight rate is disruptive. If your goal is to reduce the balance sheet, you have to do it by changing the institutional arrangements that generate the demand for reserves."  

REDUCING DEMAND

The balance sheet is already near its minimum level determined by demand factors and must grow slowly to stay at that point, as evidenced by the Fed's reserve management purchases of Treasury bills starting in December, Cecchetti, now at Brandeis University, argued in a recent blog post co-authored with New York University economist Kim Schoenholtz. 

Banks’ aggregate demand for reserves is now the key driver of the balance sheet size, and a consensus appears to be forming around finding ways to reduce that demand before supplying fewer reserves, Cecchetti said. 

FOMC members Lorie Logan and Stephen Miran and a number of Fed economists and academics have weighed in on the topic in recent months, suggesting a range of tools including netting for intraday interbank payments, relaxing restrictions on intraday borrowing from the Fed, changes in liquidity regulation and temporary open market operations. 

The most structurally significant reform -- adding a payment-netting queue to the Fed's Fedwire system, as Stanford University's Darrell Duffie has proposed -- could allow banks to offset large outgoing payments against incoming ones, trimming the reserves they need to hold. International examples from the Bank of England and Bank of Japan suggest meaningful reductions in required intraday liquidity are possible, Cecchetti said. 

But retooling the world's largest payment system is a complex multi-year project, he said. (See: MNI: Fed Repo Operations Would Shrink Balance Sheet - Duffie)

UNTESTED AT SCALE

Another difficult reform worth examining independent of the balance sheet debate is destigmatizing regular borrowing from the Fed, he said. 

Since the 2008 financial crisis, large banks have shifted from relying on intraday central bank credit to pre-loading their reserve accounts at the start of each day, a reflection of supervisory expectations that can and should be relaxed. 

Still, he and Schoenholtz are skeptical of Fed Governor Miran's estimate that 13 policy changes could generate USD1.3 trillion of reserve demand reduction, saying it depends on reduced stigma around using Fed facilities -- already proven to be difficult -- and would come at a cost of substantial interest rate volatility. 

"They might spend a lot of time stuck at their ceiling, which is the standing repo operations rate," he said. "There's a long list of things and some projections on what might happen, but nobody's tried to do it at the scale that you're talking about. You'll have to study their costs and benefits, make sure that there aren't unintended negative consequences, then slowly roll them out, and then you still don't really know what the aggregate impact is going to be until you do it." (See: MNI POLICY: Long Road To Scarcer Reserves For Warsh)