Rethinking the Fed's Balance Sheeet
The size of the Federal Reserve’s balance sheet has grown considerably over the last few decades. At its peak, the balance sheet was $9 trillion. It is currently below $7 trillion, but reducing it further is a priority for new Fed Chair Kevin Warsh.
Well before he became Chair of the Federal Reserve, Kevin Warsh took the view that the Fed's large-scale asset purchases, which greatly expanded its balance sheet, kept interest rates artificially low and primarily benefited Wall Street investors over average Americans. Warsh has favored directing money into the economy by increasing private-sector lending rather than accumulating assets on the balance sheet. In addition, he’s noted his preference to tighten monetary policy by reducing the balance sheet instead of raising interest rates, which negatively impacts both consumer and housing markets. However, to do so without market disruptions, financial deregulation is needed first.
The Great Financial Crisis (GFC) led to increased capital requirements for banks, with the goal to better protect against losses. However, federal regulators – e.g., the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) – are now looking to roll back some of these regulations on banks. The goal would be to remove unnecessary constraints placed on banks following the GFC, allow banks to expand their balance sheets and boost lending, and allow banks to become more active buyers of U.S. Treasury securities. That would then allow the Fed to further shrink its balance sheet since private sector banks could more easily absorb new Treasury supply.
This three-stage process focuses on leverage ratios, capital requirements, and liquidity requirements. It began last year, even before Warsh joined the Fed, and will continue into next year. The goal is not to shrink the balance sheet to pre-Great Financial Crisis levels, but to reduce it by as much as an additional $1 trillion.
Because the rulemaking process takes time, reducing the Fed balance sheet will likely be a 2027 story, rather than a near-term solution. Further, if another interest rate hike is viewed as necessary in 2027, it is possible that the Fed could focus on balance sheet reduction to tighten policy instead. Theoretically, that would put less pressure on consumer spending via higher rates. Regulators are hoping that the newly calibrated regulatory regime will not only allow the Fed to shrink its balance sheet but will also allow banks to increase lending (potentially at lower rates), support economic activity, and help the U.S. Treasury to finance the large fiscal deficit – all without compromising the safety and security of the banking system. It might be a bit esoteric, but it’s a critically important story we’ll be watching closely next year.
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