By Michael S. Derby
June 16 (Reuters) – In the run-up to becoming leader of the Federal Reserve, Kevin Warsh flagged as a cornerstone issue his belief that the central bank’s bond holdings must be reduced because they are too big and harmful to the U.S. economy.
Now that he’s in charge, he will get to see if he can win over skeptical colleagues to his view.
Warsh wraps up his first Federal Open Market Committee meeting on Wednesday with policymakers expected to hold interest rates unchanged as they wrestle with inflation pressures, and he may be asked to weigh in on Fed balance sheet matters at his inaugural post-meeting press conference.
Fed watchers reckon he’ll hold off on fully engaging on it for now given near-term economic challenges facing the Fed. The complexity of the debate may also slow turning his long-running dream into reality.
The balance sheet is ultimately a “2027-28 story,” said William Dudley, former leader of the New York Fed. The process will take “a lot of time” to build consensus and reshape liquidity regulations that would allow the Fed to hold fewer bonds while still maintaining control over short-term interest rates, he said.
‘QUITE A BIT OF HARM’
At his confirmation hearing in April, Warsh said Fed asset purchases have enmeshed the central bank in politics and policy decisions that should be the province of elected officials, saying they have also complicated efforts to change the Fed’s short-term interest rate target, its primary policy tool. The growth of Fed bond holdings had done “quite a bit of harm” and he said he’d work with the Treasury Department to engineer smaller holdings.
Derek Tang, an analyst at research firm LH Meyer, said Warsh’s aim “speaks to a general concern, especially among Republicans … (that) too much of the discretion over financial liquidity sits at the Fed instead of at Treasury or in other places where people are directly elected.”
Since the 2007-2009 global financial crisis, the Fed has used periodic large-scale purchases of Treasury and mortgage bonds to stabilize stressed financial markets and augment the potency of interest rate policy. It’s also created a suite of tools to manage holdings that have fundamentally changed the way monetary policy is conducted.
Total Fed holdings rose from a pre-crisis level of under $1 trillion to a peak of around $9 trillion in mid-2022 before the Fed started reducing them. They now stand at $6.7 trillion, and the balance sheet has been growing modestly over recent months due to technical adjustments to ensure the financial system has enough liquidity.
The Fed has also sought since the end of last year to rebalance its holdings toward shorter-dated securities and to better match the average maturity of the broader Treasury bond market. While this process has a long way to go, observers note some progress is being made.
SMALLER FOOTPRINT
There’s an emerging consensus that the Fed balance sheet can be shrunk by changing the rules that govern how banks manage liquidity.
Fed Governor Christopher Waller said that could allow the Fed to shed as much as $500 billion, while Dudley sees a potential $1 trillion downsizing. But that still leaves the Fed balance sheet well above where it was when the COVID-19 pandemic struck in 2020.
A primary argument against extensive Fed holdings of Treasuries and MBS is that it distorts the market and pricing for these securities. The holdings also influence government financing costs and have pushed the Fed into an unusual loss-making position.
But lowering how much liquidity banks keep on hand potentially decreases their ability to respond to stresses, which could also drive banks to more aggressively tap into Fed liquidity facilities when times get tough.
“To the extent that we could reduce the government’s footprint in private markets, yes, that would be a preferred outcome. The question is, how do you do so without sparking risks to financial stability, and there’s never been a good answer to that question,” said Daleep Singh, chief global economist at PGIM, who also served at the New York Fed and Treasury Department. Singh, who said liquidity rule changes and other tweaks could yield as much as $1.5 trillion in balance sheet cuts, added there’s ample scope to shrink holdings before stability risks begin to loom.
Richard Berner, a professor at New York University, also said he was “sympathetic” to concerns large levels of Fed holdings are distorting market price signals but added “unless you’re going to change the operating regime” that manages interest rates and market liquidity “it’s going to be challenging to reduce the balance sheet without creating a big trade-off in money markets.”
Many economists as well as key Fed officials have defended the current “ample reserves” system as providing reliable control over the central bank’s rate target. They also reject the idea that markets have been distorted, and officials like Fed Governor Michael Barr have noted the mechanics of a smaller balance sheet might even force the Fed to more actively manage market liquidity through regular interventions.
All things being equal, Warsh would likely be unable to simply order the Fed to run down its holdings absent notable liquidity rule changes because the current system of rate control would start to fail if liquidity became too tight. Liquidity shortages at the end of last year drove the Fed to start buying Treasury bills to rebuild market cash levels.
The recent decision to continue with the technical reserve management purchases suggests to Wrightson ICAP that balance sheet issues are on the back burner for now. “It never seemed likely that Chairman Warsh would step in to shift the trajectory of the Fed’s portfolio before his first official FOMC meeting, but it was still reassuring to see a business-as-usual signal.”
(Reporting by Michael S. Derby; Editing by Dan Burns and Andrea Ricci )
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