Fed Balance Sheet bloated from paying interest on reserves

The Fed Chair nominee, Kevin Warsh, has indicated he wants to shrink the size of the Fed’s balance sheet.  Right now, that is easier said than done.

Since the global financial crisis, the U.S. bond market has come to depend on the Fed to absorb a large chunk of Treasurys outstanding. By effectively monetizing U.S. debt, the Fed has helped to keep interest rates lower than they might otherwise be, while ushering in an era of strong stock-market returns.

Many believe that paring back the balance sheet without provoking at least some volatility in financial markets would probably be tricky. But there is one potential solution that they may be overlooking.

Very few market participants understand that the size of the Fed’s net balance sheet is closely related to the target Fed funds rate. 

Every day, the New York Fed conducts daily open market operations to try and keep the effective Fed funds rate – an important interest-rate benchmark in global financial markets -- within the target range set by the Fed’s policy-setting committee.

To accomplish this goal, the Fed must maintain a net balance sheet consistent with the current target range of interest rates.  Like any other bank, the Fed’s balance sheet consists of assets – mostly the bonds it has purchased via open-market operations – and liabilities, which include currency outstanding, bank reserves plus treasury deposits at the Fed.

This restricts how quickly the Fed can pare back the assets on its balance sheet. But there is one potential workaround that the central bank could use to reduce the balances on the liabilities side of its balance sheet, which would help it to justify reducing its massive hoard of bonds.

If Warsh really wants to bring down the size of the balance sheet while simultaneously lowering rates, he should probably start by focusing on the liabilities side of the equation.

In my view, the only way the Fed can reduce the size of its balance sheet without raising the Fed Funds rate is to modify or eliminate its policy of paying interest on bank reserves held at the Fed.  Right now, banks are incentivized to hold cash reserves at the Fed because they receive the same return as they would by lending cash to other banks vs. the old regime where they were de facto penalized for holding reserves by receiving zero interest.   Prior to the GFC, most banks kept Federal Reserve balances close to the regulatory requirement which ranged from 3-10% of deposits prior to the Fed eliminating reserve requirements in 2020.  Banks currently hold $3.1 trillion of reserves at the Fed while the average level of reserves was less than $10 billion prior to the GFC.

This policy of paying interest on reserves was implemented after the 2008 Financial Crisis to help the Fed to lower rates without radically reducing the size of its balance sheet.  If interest on reserves were reduced or eliminated, banks would likely significantly reduce the amount of reserves they park at the Fed.

To be sure, such a decision would come with its own host of complications. Banks holding excess reserves at the Fed arguably makes the banking system more resilient. Plus, big bank CEOs might not appreciate the hit to bank profitability.  Lowering interest on reserves would not change the Fed Funds rate which is determined by Fed open market operations.

Personally, we do not believe the current size of the Fed’s net balance sheet – which stands at approximately $6.3 trillion -- is problematic. Warsh might be better off focusing on other things, like reviewing the central bank’s arbitrary 2% inflation target, or overhauling the Fed’s forecasting models to incorporate growth in the monetary base as a key indicator of future inflation.

But if Warsh really wants to tackle this, it can be done. It just might not be very popular.