Home

Two months ago, we argued that the Federal Reserve's balance sheet was already near its minimum level determined by demand factors, and that shrinking it significantly would risk heightened interest rate volatility without major changes that would themselves carry costs. To be sure, a smaller balance sheet is a worthy goal. It would reduce the Fed's presence in credit markets, limit the fiscal-like character that large-scale asset purchases acquire over time, and preserve dry powder for the next crisis.

Since our February post, both Fed policymakers and academicians have explored the factors influencing banks’ aggregate reserve demand, which is now the key driver of the Fed’s balance sheet scale. While they generally are more optimistic about reducing reserve demand, their proposals have not altered our judgment about the desired sequencing and pace of reserve management reforms.

Importantly, the proposed demand-reducing tools are largely untested at scale in the U.S. financial system. We do not know whether they would work as intended, how large their effects would be, or what unintended consequences they might produce. That uncertainty leads us to counsel caution and care, not confidence, as policymakers consider next steps.

This post discusses a range of reform options that are taking shape.

Whether the Federal Reserve’s balance sheet is big depends on your perspective. The current level of $6.5 trillion is more than six times the level before the Lehman Brothers failure in September 2008. It is also far above the pre-pandemic level of $4 trillion. At the same time, it is $2 trillion below the May 2022 peak of $8.9 trillion. As we noted in our July 2021 post, central bank balance sheets tend to expand sharply during periods of financial stress and do not contract back to their initial level. On occasion, this ratchet has the highly undesirable character of government finance.

Kevin Warsh – the President’s choice to succeed Jay Powell as Chair of the Federal Reserve Board – believes that the Fed’s balance sheet should shrink significantly. Whether he would like to return to the 2019 level of $4 trillion, or to the pre-Lehman level, we don’t know. Regardless, it raises a fundamental question: How should the Federal Reserve manage its balance sheet, and what are the risks of reducing it significantly from its current size?

To anticipate our conclusions, we believe that the current level is close to the level determined by demand factors in the current regulatory and market environment. Unless there are major changes in the Federal Reserve's operations or in regulatory arrangements, shrinking the balance sheet risks significant interest rate volatility that could undermine financial intermediation and credit provision. Reducing reserve demand by relaxing liquidity requirements could leave the banking system more vulnerable to a panic.