The nomination of Kevin Warsh as a potential key figure in the next administration’s economic policy has reignited a long-standing debate within the halls of the Federal Reserve. Warsh, a former Fed governor known for his hawkish leanings and emphasis on market discipline, has frequently advocated for a more streamlined central bank. At the heart of his philosophy lies a desire to significantly reduce the size of the Federal Reserve’s multi-trillion-dollar balance sheet, which he views as an overextension of monetary authority that distorts financial markets.
However, the path to a smaller balance sheet is fraught with structural complexities that could make his vision difficult to realize. Since the 2008 financial crisis and the subsequent response to the 2020 pandemic, the Federal Reserve has shifted from a scarce-reserve regime to an ample-reserve framework. This transition was not merely a choice but a necessity to maintain stability in the overnight lending markets. Shrinking the balance sheet requires draining liquidity from the banking system, a process that historically leads to volatility if handled too aggressively.
One of the primary obstacles Warsh would face is the inherent demand for reserves by commercial banks. Under current regulatory standards, banks are required to hold significant amounts of high-quality liquid assets to ensure they can survive sudden outflows. While the Fed can theoretically sell off its holdings of Treasury securities and mortgage-backed bonds, it must do so without causing a spike in repo rates. We saw the dangers of miscalculating this balance in September 2019, when a sudden shortage of liquidity forced the Fed to intervene abruptly to prevent a freeze in the financial plumbing.
Furthermore, the federal government’s fiscal trajectory presents a direct challenge to any effort to minimize the Fed’s footprint. With the national debt continuing to climb and the Treasury Department issuing massive amounts of new debt to fund the deficit, the market relies on a certain level of central bank participation to ensure smooth auctions. If the Fed retreats too quickly while the supply of government debt remains at record highs, private markets may struggle to absorb the issuance, leading to higher borrowing costs for everyone from homebuyers to large corporations.
Warsh has often argued that a bloated balance sheet invites political interference and blurs the line between monetary and fiscal policy. He suggests that by holding such a large portion of the nation’s debt, the Fed becomes an enabler of government spending. While this ideological stance resonates with many fiscal conservatives, the operational reality is that the Fed’s portfolio has become an integral component of global financial stability. Withdrawing that support requires more than just a philosophical shift; it requires a complete recalibration of how the world’s largest economy functions.
There is also the matter of the Fed’s dual mandate. If a rapid reduction in the balance sheet leads to a tightening of credit conditions that hurts employment or slows growth, the central bank would find itself at odds with its legal obligations. Warsh would need to build a consensus among the Board of Governors and the regional presidents, many of whom are wary of the unintended consequences of aggressive quantitative tightening. The delicate dance of managing inflation without triggering a liquidity crisis is a challenge that has humbled many seasoned economists.
Ultimately, the debate over the Federal Reserve’s size is a debate over the role of the state in the modern economy. Kevin Warsh represents a school of thought that seeks to return to a more limited, traditional form of central banking. While his appointment could signal a shift in rhetoric, the technical and fiscal realities of the current era suggest that the era of a massive Federal Reserve balance sheet may be here to stay for the foreseeable future.
