The nomination of Kevin Warsh by Donald Trump for the next Federal Reserve Chair has sparked market attention regarding a potential adjustment in the relationship between the Fed and the Treasury Department. Warsh has long criticized the excessive size of the Fed's balance sheet, advocating for a significant reduction of its current $6.6 trillion bond holdings. He has proposed reaching a new agreement with the Treasury, similar to the 1951 "Fed-Treasury Accord," to redefine the policy boundaries between the central bank and fiscal authorities. Treasury Secretary Scott Bessent holds a similar stance. Hedge fund investor Stanley Druckenmiller recently told the Financial Times he was encouraged by the impending collaboration between the two, calling a potential agreement an "ideal scenario." Druckenmiller was formerly the employer of both Bessent and Warsh. However, analysis indicates that substantially shrinking the Fed's balance sheet faces multiple practical challenges. Historical experience shows that every previous attempt by the Fed to reduce its balance sheet has triggered money market stress. In 2013, merely hinting at a gradual reduction in bond purchases caused the globally disruptive "taper tantrum." Furthermore, aggressive balance sheet reduction could directly push up long-term interest rates, which Bessent has previously identified as a key financial indicator. Investors and Fed watchers are closely monitoring Bessent's testimony before Congress on Wednesday and Thursday for clues about the future direction of policy coordination. The historical lessons of the 1951 Accord After World War II, the Fed and the Treasury engaged in a fierce struggle over monetary policy independence. The Fed, concerned that excessive monetary stimulus was fueling inflation, wanted to exit the policy of suppressing Treasury yields to finance the war effort. However, the Truman administration insisted on maintaining low rates to control federal borrowing costs. In 1951, the two parties finally reached the "Treasury-Fed Accord": the Fed ceased artificially suppressing yields through large-scale bond purchases and gained the authority to independently use policy tools to combat inflation. This agreement is regarded as the cornerstone of the modern Fed's monetary policy independence. Warsh argues that the Fed's resumption and continuation of massive Treasury purchases during the 2008 global financial crisis and the COVID-19 pandemic has essentially deviated from the spirit of the 1951 Accord. He believes that by absorbing huge amounts of government debt, the central bank has facilitated the persistent expansion of fiscal spending, leading US debt to climb to "dangerous levels," meaning the Fed has crossed a line and indirectly ventured into fiscal policy territory. Possible contours of a new agreement Neither Warsh nor Bessent has provided detailed specifics on the framework of a so-called "new agreement." Bessent has explicitly stated he only supports the Fed purchasing Treasuries under "genuine emergency conditions and in coordination with other parts of the government." A simple new accord might merely formalize this principle, similar to how Congress amended the Fed's emergency lending authority after the 2008 financial crisis, requiring Treasury Secretary approval for any new liquidity facilities aimed at non-bank borrowers. However, Warsh's proposals are evidently more radical. He has called for returning the Fed's balance sheet to its pre-2008 financial crisis size, effectively demanding the central bank significantly shrink its asset holdings, which have ballooned due to years of quantitative easing. Practical obstacles to balance sheet reduction According to Reuters analysis, significantly reducing the scale of bonds held by the Fed faces notable structural constraints. Financial realities strongly suggest this process would be slow, difficult, and potentially impossible to complete thoroughly. The current structure of the Fed's assets and its interest rate management mechanism in an ample liquidity environment are designed to balance market stability with monetary policy goals, leaving limited room for contraction. If a Fed Chair aims to lower short-term borrowing costs, actively and substantially reducing bond holdings would tighten financial conditions, creating a contradiction with policy objectives. Joe Abate, an interest rate strategist at SMBC Capital Markets, pointed out that Warsh "may want to shrink the balance sheet and reduce the Fed's footprint in financial markets," but "actually shrinking it is not feasible... the banking system needs reserves at the current level." When bank reserve levels fall below approximately $3 trillion, money market rates tend to experience significant volatility, potentially weakening the Fed's control over its interest rate targets, which constitutes a practical boundary for balance sheet contraction. Furthermore, any major policy shift requires support from a majority of the Fed's internal policymakers. Current officials generally accept the balance sheet as a standard policy tool and may be hesitant about attempts to redesign this toolkit. Potential path for gradual adjustment Analysts note that reducing the regulatory burden on bank liquidity management and enhancing the attractiveness of central bank liquidity mechanisms, such as the discount window and the Standing Repo Facility, could gradually alleviate banks' demand for high reserves. This, in turn, might create space for the Fed to reduce the size of its balance sheet over the long term. David Beckworth, a senior research fellow at the Mercatus Center at George Mason University, stated that besides these measures, Warsh could also use the Fed's existing policy framework review process to re-examine how the balance sheet is used. Additionally, the Fed and Treasury might coordinate through operations like bond swaps. He commented: "The Fed is like a large ship that turns slowly, which is probably a good thing, because overly abrupt adjustments could shock the financial system." Evercore ISI analysis believes any action Warsh takes regarding the balance sheet will be gradual and cautious, mindful of the risks of aggressive adjustments. The firm stated: "We believe he will be more pragmatic than outsiders expect, committed to avoiding sudden shifts in Fed balance sheet policy, and will reach an agreement with the Treasury to establish a framework for closer policy coordination." Analysts added: "The market might interpret this as giving Treasury Secretary Bessent a 'soft veto' over any balance sheet reduction plans, a prospect Warsh might be open to."
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