Internal debate within the Federal Reserve regarding the size of its balance sheet is becoming increasingly public. On May 14, Federal Reserve Governor Michael Barr delivered a strongly worded speech, directly labeling current proposals for balance sheet reduction as a "mistaken objective." He warned that such plans would undermine banking sector resilience, hinder money market functioning, and ultimately threaten financial stability.
Barr presented two core arguments:
First, the size of the balance sheet is not the correct metric for gauging the Federal Reserve's degree of market involvement. Second, many of the circulating proposals for balance sheet reduction would significantly diminish the efficiency and effectiveness of monetary policy operations while increasing financial stability risks.
Notably, this speech coincided with the day that Phillip N. Jefferson was formally sworn in as Vice Chair of the Federal Reserve Board. Jefferson has been a proponent of substantially reducing the Fed's $6.7 trillion balance sheet.
Barr emphasized at the outset of his speech:
"I think shrinking the balance sheet is the wrong objective, and some of these proposals would actually increase the Fed's footprint in financial markets."
This statement was quickly highlighted by prominent financial journalist Nick Timiraos, often referred to as the "Fed's new mouthpiece," drawing widespread market attention.
**Key Arguments for Balance Sheet Reduction Challenged**
Barr systematically rebutted several common arguments for reducing the balance sheet.
Addressing the idea of "cutting reserve requirements to shrink the balance sheet," he noted that reserves are the safest and most liquid assets in the financial system. An ample supply is crucial for the sound operation of the banking system, the smooth functioning of the payment system, and overall economic stability. He cited previous remarks by Chair Jerome Powell, stressing that insufficient bank reserves could impair the payment system and create bottlenecks and stress in funding markets; in extreme scenarios, panic from depositor runs could follow.
Barr also pointed out that providing reserves carries almost no net cost for the Fed. The Fed pays interest on reserves while earning interest on its Treasury holdings, with all excess earnings remitted to the Treasury. Therefore, Barr stated:
"It makes no economic sense to make a free good scarce."
Regarding the assertion that "reducing the level of reserves will decrease the Fed's footprint in markets," he clearly stated that the Fed's involvement in the financial system is not only reflected in the duration, composition, and size of its balance sheet but also in its roles in bank supervision, payment system operation, and financial stability safeguards. Discussing "reducing the footprint" in isolation from these functions is one-sided.
**Lowering Liquidity Requirements: The Wrong Goal and the Wrong Tool**
Barr directed criticism at a notable proposal to reduce reserve demand by lowering bank liquidity regulatory requirements. He explicitly stated this is both the "wrong goal" and the "wrong tool." Currently, banks must hold sufficient High-Quality Liquid Assets (HQLA) to withstand stress scenarios, a core regulatory framework established after the 2008 global financial crisis.
Barr argued that the banking stresses of 2023 demonstrated that liquidity requirements should be increased, not decreased. Addressing proposals to allow banks to count a portion of non-HQLA assets (like corporate loans) pledged at the discount window toward liquidity requirements, Barr stated this would effectively lower liquidity requirements, reducing banks' self-insurance capacity and weakening the overall resilience of large banks. He also expressed skepticism about whether such adjustments would materially affect reserve demand.
He further noted the historical precedent of reducing banks' self-insurance. When large banks cannot withstand shocks, unconventional interventions are often needed to preserve financial stability. Barr emphasized:
"This is clearly not an outcome anyone wants, and it is certainly not a way to reduce the Fed's footprint in markets."
**TGA and "Ample Reserves Floor" Plans Also Have Flaws**
Barr also evaluated several other categories of balance sheet reduction proposals.
Regarding suggestions to shrink the size of the Treasury General Account (TGA), he noted that the TGA size is determined by the Treasury Department, not the Fed. Even if the TGA shrinks, it would not meaningfully reduce the official sector's involvement in markets. He stressed that maintaining the Treasury's ability to meet its obligations under all circumstances is in the common interest of all market participants.
For proposals to "hedge TGA balance fluctuations," he pointed out this would require the Fed to frequently conduct large-scale asset purchases and sales, especially around debt ceiling cycles, representing "another form of a larger footprint."
Barr also took a cautious stance on the "ample reserves floor" framework. Using the example of the 2019 repo market rate spike, he explained that operating with low reserve levels leads to significant rate volatility and increases the risk of losing control. If reliant on standing repo facilities or the discount window to maintain rate control, the Fed would have to frequently inject liquidity into markets. He stated:
"This is also a larger footprint, not a smaller one."
The Fed's decision to begin a gradual balance sheet expansion before the end of 2025 helped avoid a repeat of such a scenario.
**Returning to Fundamentals: Identifying the Problem Before the Policy Tool**
In concluding his speech, Barr called for a return to the fundamental logic of policy discussion. He stated that before considering any adjustments to how the Fed manages its balance sheet, the first question should be: What problem are we actually trying to solve?
He reiterated that the Fed plays an important role in the financial system, but its market footprint cannot be simplistically defined by the size of its balance sheet. Some balance sheet reduction proposals, while shrinking the on-balance-sheet size, actually expand involvement in other ways. The most prominent proposals, especially lowering liquidity requirements, would cause material harm to financial stability.
Barr summarized his speech with this statement:
"Shrinking the Fed's balance sheet is the wrong goal. Weakening the resilience of the banking system is the wrong tool."
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