Donald Trump’s nominee as the next chairman of the US Federal Reserve Board, Kevin Warsh, wants to shrink the bank’s balance sheet significantly. That’s not a riskless objective.
Warsh believes that a smaller Fed balance sheet would help drive higher economic growth and lower inflation because, in his view, the expansion of the balance sheet by printing money has pumped up the financial system and created inflation without boosting growth in the real economy.
He also thinks a big balance sheet that suppresses US rates encourages governments to spend too much, although perhaps he should have a conversation with the man who nominated him about the US government’s $US38 trillion ($54.3 trillion) – and rapidly growing – debt if he thinks that’s a major problem.
He was, of course, on the Fed’s board when its first bout of quantitative easing (QE) – buying Treasury securities and securitised mortgages to lower long-term interest rates and support asset values – began in response to the 2008 financial crisis, but has been a QE critic since leaving the board in 2011.
That bond-buying from 2008 grew the Fed’s balance sheet from about $US900 billion to just over $US4 trillion before the Fed’s response to the pandemic – a far bigger round of QE – blew it out to almost $US9 trillion.
In mid-2022 the Fed began quantitative tightening (QT), or allowing bonds to mature without reinvesting the proceeds. That program, which ended on December 1 last year, shrunk the balance sheet to about $US6.6 trillion.
While QT mighty have formally ended, however, the Fed has been buying Treasury bills – short-term securities – at a rate of $US40 billion a month, with that buying persisting until at least April.
It is that buying which (despite the Fed’s denials) represents a form of QE, that points to the inherent risk in Warsh’s ambition.
QE helped save the US and global financial system. The Fed and other central banks persisted with their bond buying long after the crisis had passed, however. That was because, in the aftermath of the crisis, economies were either in recession or not growing. There was little, if any, inflation – central bankers were fearful of deflation – and central bank interest rates were at or below zero.
There is an argument that the Fed let its original QE program run too long, but in any event the pandemic forced its hand, leading to a much bigger round of bond and mortgage purchases – and to a massive outbreak of inflation as global supply chains froze.
The Fed and its bloated balance sheet didn’t cause that outbreak of inflation, it was responding to it.
Its policies – increased interest rates and QT – have pushed the rate down from its peak of about 9 per cent to at or just below 3 per cent, although Trump’s tariffs have contributed to it being above the Fed’s target of 2 per cent and may yet push the rate back up again as their full effect flows through this year.
While Warsh wants to shrink the Fed’s balance sheet, reducing its footprint in the US financial system and economy to allow the private sector to take up the slack and make more market-driven decisions, there are some inflexible components in the Fed’s accounts.
Among the Fed’s liabilities are the US currency in circulation, which amounts to about $US2.4 trillion at present, although the amount grows as the economy grows. There’s also the US Treasury account (the Fed is the government’s banker), which fluctuates materially as cash flows in and out, but is currently around $US900 billion.
Finally, there are reserves, or deposits from banks to the accounts they hold at the Fed. They are the highest quality and most liquid assets in the financial system, used for interbank payments and managing the banks’ liquidity.
Warsh can’t do much about the currency liabilities or the government’s account, so there’s a core of about $US3.3 trillion (and growing) of Fed liabilities that can’t be shrunk, leaving the reserves as the focus for his attention.
Those reserves have grown dramatically since the 2008 financial crisis, partly because the Fed started to pay interest on them to attract them in order to have what it now describes as “ample” reserves in the financial system and partly because the post-crisis banking reforms introduced liquidity regulations that forced banks to hold a lot more high-quality liquid assets.
Warsh seems to believe that rolling back some of that regulation would release reserves to help Wall Street better fund Main Street, at lower interest rates. Instead of the “Fed put,” or a conviction that the Fed will always intervene to prop up asset markets in moments of stress, the markets would have to price risk into asset prices.
The Fed’s balance sheet could be made smaller. Banking deregulation and allowing more of the bank’s holdings of government securities to mature without reinvestment would do that.
It could, however, have significant implications for the stability of the US and (because of the primacy of the US dollar and markets) global financial systems. It could make them more volatile and more at risk of a meltdown.
In 2019, something odd and scary occurred within the US system. The cost of short-term borrowing within the “repo” market – where borrowers provide high-quality collateral, like Treasury securities, in return for short-term cash – abruptly soared.
Where interest rates in that market generally sit within the band targeted by the Fed, which was between 2 and 2.25 per cent at the time, they spiked as high as 10 per cent, signalling an acute shortage of cash in the system, similar to the seizure in the market during the GFC, when Lehman Bros and Bear Stearns were failing and banks became too scared to lend to each other.
An immediate intervention by the New York Fed, which injected the equivalent of about $110 billion into the market, calmed things down.
Something similar was developing last December, which prompted the Fed to start its $US40 billion a month purchases of Treasury bills to ensure the market remained liquid and the rates stayed within its targeted range.
What that suggests is that there’s a very fine line between the Fed having “ample” reserves to support liquidity and a liquidity crisis in the markets.
Shrinking the Fed’s balance sheet, which means running down those reserves, transfers management of liquidity risks to the private banks even as the insurance provided by their regulatory liquidity requirements is reduced.
QE helped save the US and global financial system.
The Fed could still intervene in a crisis, but markets could be more volatile and the risk of a market meltdown would be increased.
It would also be more difficult for the Fed, without a lot more and more aggressive interventions in the market, to ensure that US short-term interest rates remained within its targeted range. It would make implementing monetary policy more complicated.
Warsh believes the US will grow more strongly, with lower inflation and lower interest rates, as a result of the productivity boom he believes artificial intelligence will drive and wants to unleash the shackles that he seems to believe the size of the Fed’s footprint in the financial system and economy have imposed on growth.
He may be right, although the timing of any productivity boom, and the degree of impact it has on the economy, is an unknown, whereas he would, if he were successful, be upending Fed policies and the structure of the US system and introducing (reintroducing?) risks that the Fed’s balance sheet has been designed to reduce before those benefits materialise, if they materialise.
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Stephen Bartholomeusz is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.Connect via email.
