MNI POLICY: Fed Prepares Balance Sheet Options For Warsh

The Federal Reserve is preparing for a high-stakes internal debate under Chair Kevin Warsh over its USD6.7 trillion balance sheet by framing its cost-benefit analyses around the stability of the financial system. 

Warsh has long targeted the Fed’s massive post-crisis footprint as emblematic of overreach and a distortion to financial markets. Conceding the public perception point, Fed staff are readying options for the new chair while defending the current ample reserves operating system as well-equipped to handle shifts in reserves and other liabilities. 

They will emphasize that a faster transition comes with more risk. Aggressively draining reserves without first lowering banks' demand would achieve little structural benefit while driving money-market rates higher and injecting dangerous volatility into funding markets. 

Some FOMC officials saw the financial plumbing break first hand in September 2019, when a liquidity squeeze sent overnight rates skyrocketing and forced emergency liquidity injections. On the other hand, a number of current members weren't present during the repo crisis and may be conceptually willing to accept more market risk.

If the Fed and other agencies lower incentives for banks to hold reserves rather than other high-quality liquid assets like Treasuries and implement supervisory changes -- signaled by Fed Governor Michelle Bowman earlier this year -- USD300 billion to USD500 billion could be drained from the system over time, market participants estimate. 

Changes in regulation or market structure that shift demand for reserves are things the Fed can match on the supply side over time, more safely shrinking the balance sheet. But regulation must be designed strictly for the safety and soundness of the financial system rather than any balance‑sheet objectives. (See MNI INTERVIEW: Warsh Signals Caution On Balance Sheet Plans)

SCARCITY

The New York Fed's trading desk can smoothly execute whatever framework the leadership mandates, Roberto Perli, manager of the System Open Market Account, said in a speech last week. 

With Hidden PDF complex policy options for shrinking the balance sheet detailed in recent academic papers, the Fed may enter a prolonged deliberative process before making decisions -- and the net reduction in reserves may be less than dramatic.

Any effort to return to a scarce reserves regime will face stiff resistance inside the FOMC.

Fed Governor Michael Barr warned this month that many of the proposals to shrink the balance sheet would threaten financial stability and could actually increase the Fed’s role in markets.

"Some people believe that we should return to a scarce reserves regime, rather than an ample one. That policy would mean a smaller balance sheet, but it would not reduce the Fed's footprint in the market, given the degree of regulation and intervention that would be needed to operate this regime," he said. (See MNI POLICY: Long Road To Scarcer Reserves For Warsh)