Kevin Warsh, a former Federal Reserve Governor once nominated by President Trump to lead the central bank, has been publicly advocating for a significant reduction of the Fed's balance sheet. However, analysis from Mizuho Securities USA indicates that achieving this goal would compel the Fed to adopt a more interventionist role in its daily money market operations. For years, U.S. policymakers have operated under an "ample reserves" framework, designed to ensure sufficient liquidity in the banking system so financial institutions can meet regulatory requirements and process payments without needing to borrow from the Fed. For the Fed, this necessitates holding a substantial portfolio of Treasury assets. A return to an environment of scarce reserves and a drastically shrunken Fed balance sheet could lead to bank account overdrafts and increase their funding needs in the overnight market, thereby amplifying money market volatility and weakening the Fed's control over its short-term interest rate targets.
Dominic Konstam, Head of Macro Strategy at Mizuho Securities, noted in a report on Monday that current reserve levels are "already near the limit of what is needed to keep the federal funds market functioning orderly." He added, "If they continue to shrink the balance sheet, this will become a problem." As a former Fed Governor, Warsh has consistently called for a major reduction in the central bank's financial footprint. The balance sheet swelled dramatically during the global financial crisis and the COVID-19 pandemic through multiple rounds of asset purchases. The Fed's balance sheet peaked at approximately $8.9 trillion in June 2022, a stark contrast to its size of just $800 billion around two decades ago. Although it has since been reduced to $6.6 trillion, the Fed has paused its active balance sheet reduction process, known as "quantitative tightening," in recent months due to concerns that excessively draining reserves could trigger market stress.
Konstam argues that if a Warsh-led Fed were to decide to resume balance sheet reduction, the optimal path for the central bank would be to adopt a suggestion made by Dallas Fed President Lorie Logan last September: shift the key short-term benchmark rate from the federal funds rate to the overnight repo rate secured by Treasury collateral. This shift would require the Fed to intervene more actively on a daily basis to counteract potentially surging market volatility. "This might allow for a more flexible balance sheet on average, but it also implies a more interventionist Fed in money market operations," Konstam wrote.
Konstam pointed out that these changes would ultimately lead eligible counterparties to rely more heavily on the Fed's Standing Repo Facility—a mechanism allowing market participants to borrow cash from the central bank using Treasury and agency debt as collateral. Although a certain "stigma" still exists around borrowing directly from the central bank in the interbank market, Konstam wrote that once banks become more willing to use the facility intensively, "this could ultimately be the most efficient path for (future) balance sheet reduction." He concluded that "greater reliance on the Standing Repo Facility should coincide with banks being more comfortable holding Treasuries, thereby reducing funding risk."
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