Kevin Warsh, nominated to lead the Federal Reserve, may aim to reduce the central bank's balance sheet, but achieving this goal would be nearly impossible without significant changes to the financial system—and even then, success is not guaranteed.

The current system used by the Fed to implement monetary policy relies on banks holding substantial reserves. The level of liquidity in the financial system, along with the tools the central bank uses to manage it, ultimately limits how much the Fed can shrink its assets while maintaining stability in money markets.

Most Fed observers believe that overcoming this market constraint would require simultaneous adjustments to how the Fed manages money market interest rates and revisions to regulations affecting banks' demand for reserves.

Analysts at BMO Capital Markets noted, “There is no straightforward path to significantly reducing the Fed’s footprint in financial markets. The reality is that a major reduction in the System Open Market Account holdings may not be feasible without regulatory reforms that lower banks’ reserve needs—a process that would take quarters, not months.”

In a February 8 blog post, Brandeis University economist Stephen Cecchetti and New York University economist Kermit Schoenholtz wrote, “We agree that an outsized central bank balance sheet facilitates government financing in undesirable ways,” while also distorting financial markets. However, under current rules and interest rate control tools, “a sharp contraction of the balance sheet would expose short-term markets to substantial volatility risks—a cure potentially worse than the disease.”

Warsh has long expressed skepticism about the Fed’s large-scale balance sheet. Late last month, the Trump administration nominated him to succeed current Chair Jerome Powell when his term ends in May. Warsh, who served as a Fed governor from 2006 to 2011, has been a consistent critic of the central bank. One of his primary concerns has been the Fed’s use of bond and cash holdings as policy tools.

From the financial crisis nearly two decades ago to the COVID-19 outbreak in 2020, the Fed has purchased large quantities of U.S. Treasuries and mortgage-backed securities to stabilize troubled markets and provide stimulus when interest rates could not be lowered further. This led to an expansion of the Fed’s balance sheet to previously unimaginable levels—peaking at $9 trillion in the spring of 2022. Even after two rounds of quantitative tightening, the balance sheet has never returned to pre-crisis levels.

To manage this system, the Fed formally established a largely automated interest rate framework in 2019, capable of both absorbing and injecting cash, along with special facilities to provide liquidity quickly when needed. Together, these mechanisms help the Fed maintain its interest rate targets as intended.

Warsh last criticized the Fed’s balance sheet management in the summer of last year, while the central bank was reducing its holdings through a quantitative tightening (QT) program launched in 2022.

QT aimed to drain excess liquidity from the financial system. The Fed indicated it would end when liquidity fell to a level that allowed firm control over the federal funds rate. By late last year, as money market rates began to rise and some institutions borrowed directly from the Fed to meet liquidity needs, that point had arrived.

The end of QT calmed increasingly volatile money markets. Ultimately, the Fed reduced its total holdings from the 2022 peak to the current $6.7 trillion. As a technical measure to manage money market rates, the Fed is now gradually increasing its asset purchases through the spring.

Could regulatory changes help? Warsh believes the Fed’s large balance sheet distorts financial markets, favoring Wall Street over Main Street. He advocates further balance sheet reduction to channel liquidity into the broader economy, arguing it might allow the Fed to set interest rate targets at lower levels.

However, the challenge to this view is that as long as banks require ample reserves, shrinking the Fed’s balance sheet by draining liquidity could cause the Fed to lose control of the federal funds rate—and thus its ability to meet inflation and employment goals.

Morgan Stanley analysts stated on February 6 that altering regulations might reduce banks’ liquidity demand, but at a cost: “Smaller liquidity buffers could raise financial stability risks.”

J.P. Morgan economists Jay Barry and Michael Feroli informed clients on Wednesday that strengthening the Fed’s mechanism for offering on-demand loans via repo operations might also give banks more confidence to hold less cash. Even so, “we do not expect the Fed to resume QT.”

Some analysts suggest that improved coordination between the U.S. Treasury and the Fed could also create some room for balance sheet reduction.

Many Fed watchers believe that, regardless of Warsh’s public statements, financial realities will likely temper any push for aggressive reforms.

In a Tuesday report, Evercore ISI analysts wrote, “We do not expect him to advocate a return to the pre-financial crisis monetary policy implementation framework,” a time when liquidity was scarce, the Fed frequently intervened to manage rates, and volatility was high.

They also noted that restarting QT is unlikely, as it would signal an unwillingness to use the balance sheet as a policy tool in the future, potentially raising borrowing costs in bond markets.