Fed chair nominee Warsh may want smaller Fed holdings, but that's not easy to do

• The Fed reduced its balance sheet from a $9 trillion peak in 2022 to $6.6 trillion by late 2025, but had to resume Treasury bill purchases in December to maintain adequate market liquidity
• Banks require roughly $3 trillion in reserves to prevent money market volatility, which limits how much the Fed can shrink its holdings without threatening its ability to control interest rates
• Analysts expect Warsh will take a pragmatic, slow approach involving regulatory changes and coordination with Treasury rather than aggressive balance sheet reduction

Summary

Kevin Warsh, nominated to become the next Federal Reserve chair, has advocated for significantly reducing the Fed's multi-trillion-dollar balance sheet, but market experts warn this goal faces substantial practical obstacles.

Key Facts:

• The Fed's balance sheet peaked at $9 trillion in summer 2022 after pandemic-era bond purchases
• Quantitative tightening (QT) reduced holdings to $6.6 trillion by late 2025
• In December, the Fed resumed technical Treasury bill purchases to ensure adequate market liquidity
• Bank reserves cannot safely fall below approximately $3 trillion without causing money market volatility

Main Challenge:

Warsh served as Fed governor from 2006-2011 and has argued the Fed's "bloated balance sheet" distorts the economy. He proposed in a November Wall Street Journal op-ed that reducing Fed holdings could enable lower interest rates to support households and small businesses. However, shrinking the balance sheet actually tightens financial conditions, conflicting with easier monetary policy goals.

Market Implications:

Analysts emphasize that banks require current reserve levels for stability, making substantial reductions a "nonstarter." Joe Abate of SMBC Capital Markets notes volatility emerges when reserves approach $3 trillion, threatening the Fed's ability to manage interest rate targets.

Possible Solutions:

Experts suggest gradual approaches including easing bank liquidity regulations, making Fed lending facilities more attractive, and coordinating Fed-Treasury bond swaps. Evercore ISI analysts predict Warsh will be "more pragmatic than many expect," implementing no abrupt changes and potentially giving Treasury Secretary Bessent influence over QT decisions.

The consensus: any balance sheet reduction would be slow, cautious, and constrained by financial system stability requirements.