In response to the aggressive balance sheet reduction proposals from incoming Federal Reserve Chair nominee, current Fed Governor Michael Barr publicly voiced opposition on Thursday, cautioning that shrinking the central bank's balance sheet is a misguided objective. Barr warned that many related proposals not only fail to reduce the Fed's footprint in markets but also threaten financial stability.
Speaking at the Money Marketeers of New York University, Barr stated that attempting to shrink the Fed's asset holdings by easing bank liquidity requirements is a "bad idea" that could endanger the financial system's safety. He emphasized that while there has been much recent discussion about reducing the Fed's balance sheet, "I think this is the wrong goal, and many of the proposals to achieve it would weaken bank resilience, impede money market functioning, and ultimately threaten financial stability—some proposals might actually increase the Fed's footprint in financial markets."
Barr explicitly noted that allowing banks to hold less liquidity as a tool for balance sheet reduction would likely increase these institutions' reliance on Fed liquidity facilities during times of stress. Reflecting on the 2023 banking sector pressures, he remarked, "If anything, liquidity requirements should be increased, not decreased."
He further stressed that the size of the Fed's balance sheet is a "flawed metric" for measuring its market presence. In a system where creating reserves costs the Fed nothing, the real focus should be on the effectiveness of monetary policy implementation. "The current framework has achieved monetary policy goals for years, and effective policy implementation has also supported smooth market functioning," Barr added.
These comments come amid a leadership transition at the Fed. The U.S. Senate narrowly confirmed the nomination of the incoming chair on Wednesday, who will succeed the outgoing chair whose term ends Friday. The incoming chair, a former Fed governor, has frequently criticized the Fed's large-scale bond purchases in recent years, arguing that asset buying during the financial crisis and the pandemic has made the Fed's balance sheet disproportionately large relative to financial markets, and that persistently large holdings of securities have somewhat distorted market prices.
During the pandemic, the Fed's purchases of Treasury and mortgage-backed securities doubled its asset holdings to $9 trillion by the summer of 2022, before reducing them by over $2 trillion through balance sheet runoff. The Fed is currently maintaining liquidity levels through technical purchases of Treasury bills, with total assets around $6.7 trillion.
Additionally, the incoming chair has suggested that reducing the balance sheet's size could allow the Fed to lower interest rates more than otherwise possible, a view that has also sparked debate.
**Practical Constraints on Balance Sheet Reduction**
A core challenge to the incoming chair's proposals lies in the current system where the banking sector is flush with reserves. The tools the Fed uses to control interest rates limit its ability to shrink its asset holdings significantly. Some within the Fed and academic circles believe amending regulations to allow financial institutions to hold less liquidity could pave the way for balance sheet reduction, but Barr explicitly opposes this approach.
It is worth noting that Barr is not the only Fed policymaker opposing balance sheet reduction. New York Fed President John Williams questioned proposals to amend rules and lower bank reserve requirements in March, and Fed Governor Christopher Waller has stated that returning to a so-called "scarce reserves" regime would be "foolish."
Barr concluded, "As we consider any changes to how the Fed manages its balance sheet, we should go back to basics and ask what problem we are trying to solve. In short, shrinking the Fed's balance sheet is the wrong goal, and weakening the resilience of the banking system is the wrong way to get there."
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