Tag Archives: Fed Balance Sheet

A Warsh Policy Scenario At the Federal Reserve

16 Monday Feb 2026

Posted by in Federal Reserve, Monetary Policy

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Kevin Warsh has been nominated by President Trump as the next Chairman of the Federal Reserve Board. He’d step into the role in May if confirmed by the Senate. Warsh has served on the Board before, from 2006-2011. During that tenure, he was basically opposed to quantitative easing and expansion of the Fed’s balance sheet, though he voted for QE1 in 2010 in deference to then-Chairman Ben Bernanke, while offering a dissenting opinion.

A Chairman Warsh would have allies some at the Fed, but whatever direction he might prefer for policy, it’s not clear that he can or would swing policy decisions. The Board of Governors has seven members, not all of whom would ally with Warsh, while the Federal Open Market Committee (FOMC), the main policy-setting arm of the Fed, has 12 voting members. And the influential Fed staff might offer resistance to Warsh’s views. Nevertheless, it’s worth asking how his views would take shape as Fed policy if they held sway.

Warsh has said the Fed’s balance sheet should shrink and that the Fed should reduce its target rate for the federal funds rate. Of course, the latter aligns with Trump’s exhortations. Sharply lower rates are desired by the Administration as a tonic for consumers and businesses. Furthermore, reducing the federal government’s interest costs on the public debt would bring a meaningful reduction in the deficit, or at least give Trump room for new spending initiatives.

Some might wonder whether shrinking the Fed’s balance sheet — selling securities to the public — is consistent with an effort to reduce rates. After all, selling securities on the open market by the Fed is usually associated with higher rates and tighter monetary policy. When the Fed’s balance sheet shrinks, we call it quantitative tightening. And yet Warsh calls for lower rates.

Whether you agree with either of the Warsh objectives, their combination can at least be reconciled. A sharp reduction or prohibition on interest paid by the Fed to banks on their reserves (IOR) would go hand-in-hand with other steps by the Fed to reduce short-term interest rates. Eliminating or reducing the rate earned on reserves would create an incentive for banks to purchase the assets that Warsh would have the Fed divest from its balance sheet. That would also have to be accompanied by the reestablishment of minimum reserve requirements for banks.

Of course, bank incentives matter only to the extent that regulations don’t stand in the way. Currently, bank regulations penalize large banks for investing in Treasuries, despite minimal risk. So-called Supplementary Leverage Ratio (SLR) rules require large banks to hold from 3% up to 6% capital against all assets on their balance sheets. In addition, long-term Treasury securities held by banks can trigger flags for rate-risk exposure, and mark-to-market rules might lead to adverse fluctuations in bank regulatory capital.

Warsh has been a critic of expansive bank regulation by the Fed. It’s likely that he would support Vice Chairwoman Michelle Bowman’s push for deregulation, and would be in the same corner on that point as Treasury Secretary Scott Bessent. New rules would take time to promulgate and implement, but surely Warsh recognizes that shrinking the Fed’s $6.5 trillion portfolio would have to be a protracted affair in any case. In fact, an effort to reduce the Fed’s balance sheet in 2019 was halted after liquidity became a concern in the repurchase market.

For perspective on the $6.5 trillion portfolio, private U.S. commercial banks currently hold about $25 trillion in assets, but total bank reserves at the Fed are almost $3 trillion, including reserves held by foreign banks. This limits the extent to which the Fed’s balance sheet can be drawn down via uptake by commercial banks.

A potential switch by the Fed from ensuring “ample reserves” to a system of “scarce reserves” sets off alarm bells among many Fed watchers and within the Fed itself. Resistance to the change is based in part on the need for adequate “backstops” to ensure the safety of the banking system under scarce reserves. In this connection, there always were backstops under scarce reserves, including a well-functioning market for overnight loans of reserves between banks (federal funds) as well as the Fed’s own Discount Window, which it operates as lender of last resort. Most importantly, a steady and reliable policy course would minimize economic and financial disruptions and therefore the need for extraordinary measures. Beyond that, in times of volatility or financial stress it’s necessary to take a longer perspective on asset valuation, rather than relying too heavily on short-term market fluctuations, before leaning into “too big to fail” solutions. In fact, Warsh has said the following:

“The Fed, as first-responder, must strongly resist the temptation to be the ultimate rescuer.

And this:

“The Federal Reserve is not a repair shop for broken fiscal, trade or regulatory policies.“

Would this approach, steadily shrinking the Fed’s balance sheet while scaling back IOR, succeed in reducing key interest rates? It could reduce some consumer and business loan rates that are indexed to the fed funds rate or to the prime rate. Long-term rates are another story, as they are governed by fundamentals like expectations of economic growth and inflation. But beyond the evolution of the balance sheet, the rate of IOR, the fed funds rate, and bank reserves, there are measures of greater interest to the full thrust of monetary policy: the rate of growth of the money supply relative to nominal aggregates like GDP.

Warsh has been described as a “inflation hawk”, and has described himself as a “student of Milton Friedman”. That should assuage any fears that a “Warsh Fed” would be inclined to monetary activism for economic or political reasons.

What Trump might want and what Warsh, as Fed Chairman, is willing or able to do are two different things. Trump has loudly called for an immediate cut in the fed funds rate of 100 basis points or more, which is not going to happen. Such a large cut in the target rate (and IOR) would alarm markets, particularly without firmly establishing the Fed’s intentions for both its inflation (or other) target and the transition to a new reserve/balance sheet regime. In fact, any future policy actions should be predicated on inflation and other economic data.

But who knows? Warsh has said that the proliferation of AI will engender massive gains in productivity, which would be a deflationary force. We can only hope! Perhaps that would provide all the rationale Warsh needs for expansionary monetary policy… a smaller balance sheet with rate cuts and non-inflationary money growth.

There have been comments from Warsh and Treasury Secretary Scott Bessent that the Fed can reach some kind of new “accord” with the Treasury with respect to the Fed’s balance sheet and debt issuance. It’s not clear what this might entail, but it could be a simple matter of clearly outlining plans to level-set market expectations. The Fed has reduced the average maturity of its Treasury debt holdings. Perhaps Bessent can persuade Warsh and the Fed to lengthen maturities as the Fed’s portfolio runs off. But there are other avenues for a possible accord, such as guides for action on the provision of liquidity by the Fed, regulatory matters, and bounds around interventions that might influence debt issuance.

Here are a few bullet points to summarize the Warsh policy scenario I outlined above:

  • Shrink the Fed’s balance sheet
  • End the ample reserves regime
  • Reduce or eliminate interest on bank reserves
  • Deregulate bank balance sheets
  • Guide rates lower and provide monetary accommodation for productivity growth

That’s a lot for a new Fed Chair to bring together. Events might conspire to prevent some of those steps, but that’s stab at a Warsh roadmap for monetary policy.

The Fed Tiptoes Through Lags and an Endless Fiscal Thicket

04 Wednesday Sep 2024

Posted by in Inflation, Monetary Policy

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The late, great Milton Friedman said monetary policy has “long and variable lags” in its effect on the economy. Easy money might not spark an inflation in goods prices for two years or more, though the typical lag is thought to be more like 15-20 months. Tight money seems to have similar lags in its effects. Debates surround the division and timing of these effects between inflation and real GDP, and too many remain convinced that a reliable tradeoff exists between inflation and unemployment.

With that preface, where do we stand today? The Fed executed a veritable helicopter drop of cash during the pandemic, in concert with support payments by the Treasury, with predictable inflationary results. It was also, in part, an accommodation to supply-side pressures. Then the tightening of policy began in the spring of 2022. How will the timing and strength of these shifting policies ultimately play out, as well as the impact of expectations regarding future policy moves?

Help On the Way?

Federal Reserve Chairman Jerome Powell and the Fed’s Open Market Committee (FOMC) are now poised to ease policy after three-plus years of a tighter policy stance. The FOMC is widely expected to cut its short-term interest rate target by a quarter point at the next FOMC on September 17-18. There is an outside chance that the Fed will cut the target by a half point, depending on the strength of new data to be released over the next couple of weeks. In particular, this Friday’s employment report looms large.

What sometimes goes unacknowledged is that the Fed will be following market rates downward, not leading them. The chart below shows the steep drop in the one-year Treasury yield over the past couple of months. Other rates have declined as well. Granted, longer rates are determined in large part by expectations of future short-term rates over which the Fed has more control.

And yet the softening of market rates may well be a signal of weaker economic activity. There is certainly concern among investors that a failure by the Fed to ease policy might jeopardize the much hoped-for “soft landing”. The lagged effects of the Fed’s tighter policy stance may drag on, with damage to the real economy and the labor market. Indeed, some assert that a recession remains a strong possibility (and see here), and the manufacturing sector has been in a state of contraction for five months.

On the other hand, the Fed has fallen short of its 2% inflation goal. The core PCE deflator, the Fed’s preferred inflation gauge, was up 2.6% for the year ending in July. Some observers fear that easing policy prematurely will lead to a new acceleration of inflation.

Powell Gives the Nod

Nevertheless, markets were relieved when Jerome Powell, in his recent speech in Jackson Hole, Wyoming, indicated his determination that a shift in policy was appropriate. From Bloomberg:

“Federal Reserve Chair Jerome Powell said ‘the time has come’ for the central bank to start cutting interest rates.

“Powell’s comments cemented expectations for a rate cut at the central bank’s next gathering in September. The Fed chief said the cooling of the labor market is ‘unmistakable,’ adding, ‘We do not seek or welcome further cooling in labor market conditions.’ Powell also said his confidence has grown that inflation is on a ‘sustainable path’ back to the Fed’s goal of 2%.“

The “sustainable path back to … 2%” might imply a view inside Fed that policy will remain somewhat restrictive even after a quarter or half-point rate cut in September. Or perhaps the “sustainable path” has to do with the aforementioned lags, which might continue to be operative regardless of any immediate change in policy. The feasibility of a “soft landing” depends on whether policy is indeed still restrictive or on how benign those lagged effects turn out to be. But if we take the lags seriously, an easing of policy wouldn’t have real economic force for perhaps 15 months. Still, the market puts great hope in the salutary effects of a move by the Fed to ease policy.

Big Balance Sheet

It can be argued that the Fed already took a step toward easing policy in May when it reduced the rate at which it was allowing runoff in its portfolio of Treasury and mortgage-backed securities. Prior to that, it had been redeeming $95 billion of maturing securities a month. The new runoff amount is $60 billion per month. Unless neutralized in other ways, the runoff has a contractionary effect on bank reserves and the money supply. It is known as “quantitative tightening” (QT). but then the May announcement was a de facto easing in the degree of QT.

Thus far, the total reduction in the Fed’s portfolio has amounted to only $1.7 trillion from the original high-water mark of $8.9 trillion. Here is a chart showing the recent evolution in the size of the Fed’s securities holdings.

The Fed’s current balance sheet of $7.2 trillion is gigantic by historical standards. It’s reasonable to ask why the Fed considers what we have now to be a more “normalized” portfolio, and whether its size (and correspondingly, the money supply) represents potential “dry tinder” for future inflation. It remains to be seen whether the Fed will further pare the rate of portfolio runoff in the months ahead.

Money growth had been running negative for roughly a year and a half, but it edged closer to zero in late 2023 before accelerating to a slow, positive rate a few months into 2024. The timing didn’t exactly correspond to the Fed’s slowing of portfolio runoff. Nevertheless, the Fed’s strong preference is to supply the banking system with “ample reserves”, and reserves drive money growth. Thus, the Fed’s reaction to conditions in the market for reserves was a factor allowing money growth to accelerate.

A Cut Too Soon?

A rate cut later this month will make reserves still more ample and support additional money growth. And again, this will be an effort to mediate the negative impact of earlier policy tightness, but the effect of this move on the economy will be subject to similar lags.

A danger is that the Fed might be easing too soon, so that inflation will fail to taper to the 2% goal and possibly accelerate again. And perhaps policy was not quite as tight as it needed to be to achieve the 2% goal. Now, new supply bottlenecks are cropping up, including a near shutdown of shipping through the Suez Canal and a potential strike by east coast dockworkers.

Fiscal Incontinence

An even greater threat now, and in the years ahead, is the massive pressure placed on the economy and the Fed by excessive federal spending and Treasury borrowing. The growth of federal debt over the 12 months ending in July was almost 10%. Total federal debt stands at about $35 trillion. According to the Congressional Budget Office (CBO) projections, federal debt held by the public will be almost $28 trillion by the end of 2024 (the rest the public debt is held by the Fed or federal agencies). The CBO also projects that the federal budget deficit will average almost $1.7 trillion annually through 2027 before rising to $2.6 trillion by 2034. That would bring federal debt held by the public to more than $48 trillion.

Inflation is receding ever so slowly for now, but it’s unclear that investors will remain comfortable that growth in the public debt can be paid down by future surpluses. If not, the only way its real value can be reduced is through higher prices. Most observers believe such an inflation requires that the Fed monetize federal debt (buy it from the public with printed money). Tighter credit markets will increase pressure on the Fed to do so, but the growing debt burden is likely to exert upward pressure on the prices of goods with or without accommodation by the Fed.

Hard, Soft, Or Aborted Landing?

Some economists are convinced that the Fed has successfully engineered a “soft landing”. I might have to eat some crow…. I felt that a “hard landing” was inevitable from the start of this tightening phase. Even now I would not discount the possibility of a recession late this year or in early 2025. And perhaps we’ll get no “landing” at all. The Fed’s expected policy shift together with the fiscal outlook could presage not just a failure to get inflation down to the Fed’s 2% target, but a subsequent resurgence in price inflation.

The Fed’s Balance Sheet: What’s the Big Deal?

08 Sunday May 2022

Posted by in Government Failure, Inflation, Monetary Policy

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The Federal Reserve just announced tighter monetary policy in an attempt to reduce inflationary pressures. First, it raised its target range for the federal funds rate (on overnight loans between banks) by 0.5%. The new range is 0.75% – 1%. Second, on June 1, the Fed will begin taking steps to reduce the size of its $9 trillion portfolio of securities. These holdings were acquired during periods of so-called quantitative easing (QE) beginning in 2008, including dramatic expansions in 2020-21. A shorthand reference for this portfolio is simply the Fed’s “balance sheet”. It includes government debt the Fed has purchased as well as privately-issued mortgage-backed securities (MBS).

What Is This Balance Sheet You Speak Of?

Talk of the Fed’s balance sheet seems to mystify lots of people. During the 2008 financial crisis, the Fed began to inject liquidity into the economy by purchasing large amounts of assets to be held on its balance sheet. This was QE. It’s scope was unprecedented and a departure from the Fed’s pre-crisis reliance on interest rate targeting. QE had the effect of increasing bank reserves, which raised the possibility of excessive money supply growth. That’s when the Fed began to pay interest to banks on reserves, so they might be content to simply hold some of the reserves over and above what they are required to hold, rather than using all of that excess to support new loans and deposits (and thus money growth). However, that interest won’t stop banks from lending excess reserves if better opportunities present themselves.

The Fed has talked about reducing, “normalizing”, or “tapering” its balance sheet for some time, but it only recently stopped adding to it. With inflation raging and monetary policy widely viewed as too “dovish”, analysts expected the Fed to stop reinvesting proceeds from maturing securities, which amounts to about $95 billion per month. That would shrink or “taper” the balance sheet at a rate of about $1.1 trillion per year. Last week the Fed decided to cap the “runoff” at $47.5 billion per month for the first three months, deferring the $95 billion pace until September. Monetary policy “hawks” were disappointed by this announcement.

Monetizing Government

So, one might ask, what’s the big deal? Why must the Fed taper its securities holdings? Well, first, the rate of inflation is far above the Fed’s target range, and it’s far above the “average Joe’s” comfort range. Inflation imposes significant costs on the economy and acts as a regressive form of taxation, harming the poor disproportionately. To the extent that the Fed’s huge balance sheet (and the corresponding bank reserves) are supporting incremental money growth and fueling inflation, the balance sheet must be reduced.

In that connection, the Fed’s investment in government debt represents monetized federal debt. That means the Fed is essentially printing money to meet the Treasury’s financing needs. Together with profligate spending by the federal government, nothing could do more to convince investors that government debt will never be repaid via future budget surpluses. This dereliction of the government’s “full faith and credit”, and the open-armed acceptance of the inflation tax as a financing mechanism (à la Modern Monetary Theory), is the key driver of fiscal inflation. Reducing the balance sheet would represent de-monetization, which might help to restore faith in the Fed’s ability to push back against fiscal recklessness.

Buyer of First Resort

Perhaps just as critically, the Fed’s heavy investment in government debt and MBS represents an ongoing distortion to the pricing of financial assets and the allocation of capital. Some call this interference in the “price discovery process”. That’s because the Fed has represented a market-altering presence, a willing and inelastic buyer of government debt and MBS. Given that presence, it’s difficult for buyers and sellers to discern the true values of alternative uses of capital, or to care.

QE was, among other things, a welcome institutional development for the U.S. Treasury and for those who fancy that fresh money printing is an ever-valid form of government payment for scarce resources. The Fed’s involvement also means that other potential buyers of Treasury debt need not worry about interest rate risk, making public debt relatively more attractive than private debt. This is a dimension of the “crowding out” phenomenon, whereby the allocation of capital and flows of real resources between public and private uses are distorted.

The Fed’s presence as a buyer of MBS depresses mortgage rates and makes mortgage lending less risky for lenders and investors. As a result, it encourages an over-investment in housing and escalating home prices. This too distorts the allocation of capital and real resources, at the margin, toward housing and away from uses with greater underlying value.

Conclusion

The magnitude of the Fed’s balance sheet is an ongoing testament to an increasingly dominant role of central authorities in the economy. In this case, the Fed has served as a conduit for the inflation tax. In addition, it has unwittingly facilitated crowding out of private capital investment. The Fed’s purchases of MBS have distorted the incentives (and demand) for residential investment. These are subtle effects that the average citizen might not notice, just as one might not notice the early symptoms of a debilitating disease. The long-term consequences of the Fed’s QE activities, including the inflation tax and distorted allocations of capital, are all too typical of failures of government intervention and attempts at central planning. But don’t expect anyone at the Fed to admit it.