Kevin Warsh's proposal to shrink the Federal Reserve's balance sheet is expected to face slow progress due to significant internal resistance. Warsh has repeatedly stated that the Fed's nearly $7 trillion balance sheet illustrates how the central bank has encroached on Congress's domain, arguing that its large-scale bond purchases under various quantitative easing programs have distorted financial markets. However, according to informed sources, Warsh would only seek changes to the Fed's balance sheet after extensive discussions with banks and the public about potential impacts.

The sources also indicated that he is unlikely to push for the balance sheet to return to its pre-2008 financial crisis size, adding that he would call for internal studies and academic conferences before taking any action. Warsh's views on the Fed's balance sheet are being closely scrutinized on Wall Street. If confirmed by the Senate to succeed Powell as Chair in May, this issue would become a major focus of discussion within the central bank.

Some of the Fed's highest-ranking officials have warned that reducing the balance sheet could trigger turmoil in money markets and jeopardize policymakers' ability to control short-term interest rates. "You don't want banks scrounging for money in the sofa cushions every night," said Fed Governor Waller, who lost to Warsh in the contest to succeed Powell, during an economic conference in Washington last week. "That is incredibly inefficient and stupid."

Over the past three years, through its Quantitative Tightening program where maturing bonds are not replaced, the central bank has reduced its balance sheet from $9 trillion to $6.6 trillion. However, it remains larger than its size before the COVID-19 pandemic. The Federal Open Market Committee's rate-setters believe it is currently difficult to shrink the balance sheet further. The FOMC paused QT in December after a bout of stress in funding markets, which officials interpreted as a sign they were close to draining too much cash from the financial system.

Fed officials stated that this tension indicates banks no longer hold "excess" reserves in the financial system, and the current level is now "ample." The Fed has also acknowledged that its balance sheet might expand again this year as banks' willingness to hold reserves grows in line with the U.S. economy. This would increase the amount of reserves needed in the system to avoid falling below the "ample" level.

The current system targeting "ample" reserves, which the Fed adopted in 2019, contrasts sharply with the reserve mechanism in place when Warsh was a Fed Governor in 2006. At that time, reserves were "scarce," and lending between financial institutions played a much larger role in influencing short-term borrowing costs. Under the ample reserves regime, the Fed encourages banks to park reserves at the central bank by paying them interest, rather than lending them out—a so-called "floor system" that gives the central bank more control over short-term borrowing costs but removes the incentive for interbank lending.

"If you really want to shrink the balance sheet, you have to get away from the operating system that tends to lead to its continued growth, namely the so-called 'floor system'," said George Selgin, a former senior fellow at the Cato Institute. The ample reserves framework has broad support on the Fed's Board of Governors, with only Governor Bowman advocating for a return to a scarce reserves system.

On Tuesday, Waller criticized the idea of reverting to a scarce reserves system, stating that it fundamentally contradicts a primary goal of economics. "The goal of economics is to reduce scarcity—that always increases welfare—not to create more scarcity," the Fed Governor said. "Scarcity is not the goal of economics. It never has been and it never should be."

While Warsh's comments have sparked speculation that he would push for a return to a scarce reserves system, he has not publicly used that terminology. People familiar with Warsh's thinking reveal that he also believes the 2008 crisis demonstrated the risks to financial stability from delegating too much responsibility to the interbank market. He has publicly advocated for a "third model" for managing the Fed's balance sheet.

Some regional Fed presidents would consider a modest shift to a new balance sheet management framework. Chicago Fed President Goolsbee, who worked with Warsh during his time as a Fed Governor, said last week that he is "personally open to thinking about all the ways we can maintain rates." Goolsbee emphasized that any change to the current framework would require "a lot of research."

Fed Governor Miki, who, like Bowman and Waller, was appointed by President Trump, has proposed shrinking the balance sheet by easing regulatory requirements. This would lead lenders to be willing to hold fewer reserves and more U.S. Treasuries. His idea has gained some internal support; influential figures on the matter, such as Dallas Fed President Logan and Waller, have both said the proposal is worth studying. "Right now, the amount of reserves banks want to hold at the Fed is about $3.1 trillion," Waller said. "With some regulatory changes, could that go to $2.5 trillion? I think it could."