MNI POLICY: Long Road To Scarcer Reserves For Fed Nom Warsh

The size of the Federal Reserve's balance sheet cannot be reduced much further under the current regulatory framework without risking its control over interest rates, making it difficult for Fed chair nominee Kevin Warsh to persuade the rest of the FOMC to restart QT or induce banks to demand fewer reserves ahead of regulatory reform. 

Dealers and depository institutions tapped the Fed's standing repo operations for over USD30 billion last week as money market rates firmed from mid-month Treasury settlements, suggesting reserve demand continues to hover around the Fed's target "ample" level and that regular asset purchases are needed to keep it there. 

Among current FOMC members there is little appetite to test a scarcer reserves regime at the cost of higher rate volatility, especially as the Fed's standing repo operations (SRP) have yet to be proven adequate to absorb swings in the Treasury General Account.

Money market volatility has now twice prompted officials to end QT earlier than anticipated, and the 2019 repo market episode that threatened to undermine the Fed's credibility on rate control hardened policymakers' bias to preempt volatility rather than react to it.

SRP counterparties have appeared reluctant so far to use the facility for various reasons, which boosted repo rates well above the SRP rate on certain days late last year. Whether last week's SRP usage, in spite of calm triparty rates, marks a shift in attitude remains to be seen. (See MNI POLICY: Fed To Start Gradual Asset Purchases Within Months)

"Warsh's views are aligned with Bessent's for a smaller, better focused and quieter Fed -- that the central bank had been far too active in too many areas. Similarly on the balance sheet, they would want a smaller footprint, and that stands in apparent contrast to the preferences of the current committee, which is comfortable with the size of the balance sheet," former St. Louis Fed President James Bullard told MNI.

DEMAND FOR RESERVES

About half of the Fed's USD6.5 trillion in liabilities are bank reserves, which have ballooned over time as banks hoarded cash to satisfy post-crisis rules. Regulatory changes would be necessary to meaningfully reduce banks' structural demand for reserves -- something Warsh and other Trump appointees including Treasury Secretary Scott Bessent and Fed governors Michelle Bowman and Stephen Miran support. However, that will take years to implement. 

Banking regulators have reduced the supplemental leverage ratio for the biggest banks, effective April 1, removing one disincentive to provide Treasury market intermediation. 

Liquidity reforms may come in the second half of the year, after regulators complete their Basel III proposal on capital changes. Easier liquidity requirements, including potentially recognizing discount window borrowing capacity in risk assessments, is expected to reduce banks' demand for reserves. 

Bill Nelson of the industry group Bank Policy Institute and former top Fed regulator Randy Quarles have argued the attitude of bank supervisors plays another role in banks holding reserves over Treasuries, on top of binding regulations. Supervisors prefer reserves and don't recognize lenders' capacity to borrow at Fed facilities as a way to get immediate funding.  

Such attitudes are deeply entrenched and a change would likely require a continuous effort spanning public statements and heavy guidance from the top.