Warsh may need five years to really shrink the central bank’s balance sheet

Federal Reserve Chair nominee Kevin Warsh wants to significantly shrink the US central bank’s $6.6 trillion balance sheet. He’ll probably need more than one term to do it, according to a top financial economist.

Darrell Duffie, a professor at the Stanford School of Business and longtime adviser to the Fed, argues in a new paper that the central bank would need to undertake reforms — including an overhaul of bank liquidity requirements and a redesign of the payment system — if it wants to substantially reduce its footprint in financial markets without causing severe stress.

Darrell Duffie at the Kansas City Fed’s annual Jackson Hole economic symposium on August 24, 2023.

Once Warsh is confirmed to the post by the US Senate, he could institute some of the reforms more or less right away, provided he has buy-in from his colleagues. Others could take up to five years, Duffie said, which would imply an effort extending beyond Warsh’s four-year term as chair.

“That’s retooling the largest payment system in the world,” Duffie said Monday on a call with reporters about just one of several steps he’s proposing. “You’re not just going to write a few lines of code and then insert them back into the system and hope that it works. It’s going to be a lot of testing.”

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In a paper published Wednesday by the Brookings Institution, Duffie outlined a set of four proposals the Fed could adopt to reduce bank demand for cash reserves held in accounts at the central bank. At the moment, banks have about $3 trillion parked at the Fed, partly to satisfy liquidity regulations imposed on them after the 2008 financial crisis.

Fed officials have embraced the setup because it also offers a simpler way to control short-term interest rates.

Warsh pick

President Donald Trump, during his search for a new Fed chair, said a desire to immediately lower rates would be a litmus test for his pick. Warsh, who ended up getting the nod, has argued that reducing the central bank’s balance sheet would pave the way for cuts. But he’s provided few details on how he might do that.

The Trump-appointed Fed Vice Chair for Supervision Michelle Bowman, and Treasury Secretary Scott Bessent, have also proposed scaling back liquidity requirements to reduce demand for reserves. Still, investors and Fed watchers have been guessing at how this could all play out. Duffie’s paper offers a road map of sorts.

First, the New York Fed could lean more heavily on temporary open market operations, a tool it has used extensively in the past. That would be the simplest way to smooth through fluctuations in reserve demand, and could take mere weeks to implement, according to Duffie.

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Next would come changes to liquidity regulations and supervisory practices. Those would likely take months to sort out, Duffie said. And the effort would require clear communication to supervisors so banks aren’t penalized for using facilities like the Fed’s discount window, which has historically carried a stigma in financial markets despite efforts to encourage its use.

The Fed could also choose to pay a lower rate on reserve balances beyond a specific target or quota. Those could be implemented rather quickly, but reaching a broad agreement on its design and communication would most likely take years, Duffie said.

Finally, the Fed could follow the example of other central banks, like the Reserve Bank of New Zealand, and introduce liquidity-saving mechanisms in its payment system. But that would require changes not only at the Fed but also at commercial banks and could take as long as five years, Duffie said.

“You can’t do much unless you reduce the demand for reserves,” Duffie said of Warsh’s desire to shrink the Fed’s balance sheet. “You could pick off one or two of these, have a little effect,” he said, referring to his four proposals. “If you want to have a lot of effect, it’s going to be quite a lot of work.”

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