Fed Balance Sheet Can Only Be Reduced by Eliminating Interest on Reserves

The Fed Chair nominee, Kevin Warsh, has indicated he wants to shrink the size of the Fed’s balance sheet. Very few market participants understand that the size of the Fed’s net balance sheet is almost exclusively driven by the target fed funds rate.  Specifically, the New York Fed conducts daily open market operations to maintain the Fed funds rate within the FOMC’s target range.  Consequently, the Fed must maintain a net balance sheet consistent with the then current target Fed Funds rate.  The size of the Fed’s net security holdings (assets), therefore, should be approximately equal to the Fed’s liabilities which include currency outstanding, bank reserves plus treasury deposits at the Fed.

An extreme example of this phenomenon is during the Pandemic the Fed set a target for increasing holdings of treasuries and mortgages by $120 billion per month.  In order to maintain Fed Fund’s above zero, the Fed needed to execute over $3.5 trillion of reverse repo whereby the Fed borrows reserves from the banking system to offset the impact of the excessive treasury and mortgage purchases. This operation was highly uneconomic for the Fed as it caused huge losses in the Fed’s balance sheet when the Fed tightened monetary policy resulting in the Fed’s current insolvency with over $100 billion of negative net worth.  Although the gross size of long-term treasuries and mortgages reached almost $9 trillion, the size of the net balance sheet (treasuries plus mortgages less repo) stabilized below $6 trillion where it has now grown to approximately $6.3 trillion.

When the Fed starting cutting rates in 2025, the Fed allowed the treasury and mortgage securities to roll off gradually but was able to lower rates by rapidly unwinding the $3.5 trillion of reverse repo so the net balance sheet (long term securities holdings, less repo) was increasing in order to facilitate an increase in bank reserves which causes the Fed Funds rate to fall.  The current amount of reverse repo is down to $300 billion, and the Fed’s securities holdings are down to $6.6 trillion from a peak of almost $9.0 trillion resulting in net securities holdings of $6.3 trillion.

Going forward, the Fed is likely to cut rates to the neutral rate of 2.5-2.75% which will be facilitated by reducing reverse repo but may eventually require an increase in securities holdings to effectuate a reduction in the Fed funds rates.  As the economy continues to grow the monetary base must continue to grow to keep the Fed Funds rate stable, requiring a gradual expansion of securities holdings.

The only way the Fed can reduce the size of its balance sheet without raising the Fed Funds rate, is to reduce or eliminate the policy of paying interest on bank reserves held at the Fed.  This policy was implemented after the Great Financial Crisis in order for the Fed to normalize rates without radically reducing the size of its balance sheet.  If interest on reserves were reduced or eliminated, banks would significantly reduce the amount of reserves held at the Fed at any given Fed Funds rate, which would reduce Fed liabilities and allow it to shrink its net holdings of securities.  This move would make the Fed more profitable but would hurt bank profitability, which would be politically unpopular. In addition, banks holding excess reserves at the Fed arguably makes banks balance sheets less risky which reduces the probability of financial stress in the banking system.

We do not believe the current size of the Fed’s net balance sheet, approximately $6.3 trillion, is problematic and that the policy of paying interest on reserves is a positive for bank profitability and stability so the focus on the balance sheet size is not appropriate.  Instead, Warsh should focus on other Fed reforms including reviewing the arbitrary 2% target, fixing the inflation indices to reflect real time market inflation, and overhauling the Fed’s forecasting models by including growth in the monetary base as a key indicator of future inflation.