By Michael S. Derby
Feb 17 (Reuters) – Kevin Warsh, nominated to lead the Federal Reserve, may want a smaller central bank balance sheet, but he’s unlikely to get it absent major tinkering with the financial system, and even then, it might not be possible.
That’s because the system the Fed now uses to achieve its monetary policy goals depends on the banking system holding large amounts of money. The level of liquidity in the financial system and the tools the central bank uses to manage it ultimately limit how far Fed holdings can be contracted and keep money markets on an even footing.
Breaking through that market gravity would require some combination of a change in how the Fed manages money market rates and regulatory changes governing banks’ appetite for reserves, most Fed watchers agree.
“There isn’t a straightforward path to a smaller Fed footprint in financial markets,” according to analysts at BMO Capital Markets. “The reality is 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 that will take quarters, not months, to unfold.”
“We appreciate that when a central bank’s balance sheet is large, it facilitates government financing that is highly undesirable,” as it also interferes with financial markets, wrote economists Stephen Cecchetti of Brandeis University and Kermit Schoenholtz of New York University in a blog post on February 8. That said, with the current rules and rate control toolkit, “shrinking the balance sheet significantly would expose short-term markets to substantial volatility risk – a cure potentially worse than the disease.”
WARSH A LONG-TIME BALANCE SHEET SKEPTIC
Warsh was tapped by the Trump administration late last month to succeed current Fed Chair Jerome Powell when his leadership term ends in May. The prospective Fed leader, who formerly served as a governor from 2006 to 2011, has been a staunch critic of the central bank. One of his main beefs has been how the Fed uses its holdings of bonds and cash as a policy tool.
Beginning in the financial crisis nearly two decades ago and then again when the COVID-19 pandemic struck in 2020, the Fed has used aggressive buying of Treasury and mortgage bonds to calm troubled markets and provide stimulus when its rate target can be cut no further. That’s caused Fed holdings to swell to once unimaginable numbers – overall holdings peaked at $9 trillion in the spring of 2022. In the two major periods of Fed balance sheet contraction, it has never come close to getting back to where it was before the buying began.
To manage this system the Fed has largely automatic rate tools formalized in 2019 that can both take in and lend cash, with special facilities to provide liquidity quickly if needed. This works together to keep the Fed interest rate target where officials want.
Warsh’s most recent critiques of how the Fed manages its balance sheet landed last summer, at a time when the central bank was reducing its holdings through an effort known as quantitative tightening, or QT, which it had started in 2022.
This process aimed to remove excess liquidity from the financial system. The Fed said QT would end when liquidity was low enough to allow for continued firm control of the fed funds rate. It reached that point late last year when a range of money market rates started to rise and financial firms were in some cases compelled to borrow directly from the Fed to manage liquidity needs.
The end of QT calmed increasingly choppy money markets. Ultimately, the Fed was able to lower its overall holdings from the 2022 peak to the current level of $6.7 trillion. It is currently rebuilding holdings into the spring as a technical measure to manage money market rates.
RULE REGIME CHANGE?
Warsh believes large Fed holdings distort financial markets and favor Wall Street interests over those of Main Street. He’s argued for a further contraction in the Fed’s balance sheet to deploy this liquidity to the economy as a whole, and reckons this could allow the Fed to set its interest rate target lower than it would otherwise be.
The challenge to Warsh’s outlook is that as long as the banks require strong levels of reserves, contracting the overall level of Fed holdings by removing liquidity from the financial system can lead to loss of control of the federal funds rate, and with it the central bank’s ability to achieve its inflation and employment mandates.
Morgan Stanley analysts said on February 6 that rule changes could diminish the desire for liquidity, albeit at a price: “Lower liquidity buffers could increase financial stability risks,” they said.
J.P. Morgan economists Jay Barry and Michael Feroli told clients on Wednesday that enhancing how the Fed provides on-demand loans to financial firms from its repo operations might also give banks confidence to hold less cash on hand. But even then, “we do not think it is likely the Fed can restart QT.”
Some analysts said tighter coordination between the Treasury and the Fed may also give the Fed some space for smaller holdings.
Many Fed watchers believe that regardless of Warsh’s public comments, financial realities will ultimately temper any big push for change.
“We think he will not push for a return” to how the Fed conducted monetary policy before the financial crisis, when market liquidity was scarce and the central bank managed interest rates with very regular interventions, amid interest rate volatility, said analysts at Evercore ISI in a report on Tuesday.
A return to QT is also off the table, they said, as it would signal to markets a reluctance to use the balance sheet as a tool in the future, which would cause bond market borrowing costs to rise now.
(Reporting by Michael S. Derby; Editing by Andrea Ricci)
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