By Howard Schneider
WASHINGTON, May 15 (Reuters) – Incoming Federal Reserve chief Kevin Warsh’s plans to shrink the U.S. central bank’s “footprint” in financial markets could be constrained by the rising federal debt and potentially lost luster of U.S. Treasuries, analysts said.
Warsh, who was confirmed by the U.S. Senate on Wednesday to replace Fed Chair Jerome Powell, has advocated for a smaller central bank role and less market intervention as part of a return to a more conventional monetary policy style that he feels can stay better focused on controlling inflation and avoiding any distortion of markets.
However attractive in theory, the approach could also reveal gaps in the market for Treasuries that would either push up long-term interest rates to the detriment of businesses, households and the government itself, or put pressure on the Fed to step in and help hold borrowing costs down, said Hanno Lustig, a finance professor at Stanford University’s Graduate School of Business. Lustig’s recent research has suggested top developed markets like the U.S. have lost their “convenience yield,” effectively a lowered rate on government debt for countries with risk-free standing and independent central banks.
If Warsh and other Fed officials “want to get ahead of this, when yields are responding to fiscal shocks, they have to … be transparent about that, rather than say ‘Oh, this is a hiccup in the Treasury market,'” that requires the Fed to buy bonds to smooth market functioning, Lustig said on the sidelines of a recent conference at Stanford’s Hoover Institution. “In order to have real price discovery in the Treasury market, we need a central bank that will not intervene.”
Warsh has been critical since his days as a Fed governor more than a decade ago of how the central bank has expanded its balance sheet during crises, or even in times of bank funding market stress, without clear guidelines on what securities it should buy, in what quantities, or a clear plan for reducing holdings afterward.
Instead, its holdings have grown and fallen through a combination of financial dark arts – probing to see just how much liquidity the banking system needs before rates start rising – and throw-everything-against-the-wall reactions to events like the COVID-19 pandemic or the 2007-2009 recession and financial crisis. The Fed currently holds about $6.7 trillion in assets, down from a peak of around $9 trillion in 2022, and the amount is again growing slowly to keep bank reserves flush.
There’s still no broad agreement about how Fed bond purchases, a process known as “quantitative easing,” affect the economy.
The U.S. central bank usually confines its monetary policy decisions to raising and lowering a short-term interest rate that influences consumer and business borrowing costs. Higher rates cut into spending when inflation is rising, and lower rates encourage spending during economic weakness.
Once its policy rate hits zero and can go no lower, however, as it has during economic shocks, the Fed can use its theoretically unlimited balance sheet – its power to create money – to intervene. The assets it buys leave the system and are replaced with cash, which helps lower longer-term rates even further to encourage spending and boost growth.
OTHER COMPLICATIONS
Fed policymakers and others generally agree that it works, at least to some degree.
But “they’re overdue for a discussion around how they use the balance sheet and under what circumstances,” said Ellen Meade, a former top Fed adviser who is now an economics professor at Duke University. “That’s a nine-to-12-month process, with staff memos and briefings, committee discussions and then agreement.”
If the aim is to both reduce holdings and hold down rates, however, it also might require closer-than-usual coordination with the U.S. Treasury, whose debt-issuance decisions could influence rates as the Fed cuts its holdings.
In a recent analysis, Bill Nelson, a former Fed staffer and now the chief economist at the Bank Policy Institute, said if the U.S. central bank used regulatory and other changes to reduce its balance sheet by another $2 trillion, the effect on its policy rate would depend heavily on how that was engineered and how the Treasury Department reacted – ranging anywhere from a 0.84-percentage-point rate cut to a possible hike.
Not everyone sees a big balance sheet as the problem Warsh believes it is.
Fed Governor Christopher Waller, noting that a main reason for large central bank asset holdings is to provide ample liquidity for banks, said proposals to curtail those holdings to the point where financial institutions compete for reserves would be “extremely inefficient and stupid.” In a recent Brookings Institution survey of top Fed and economic analysts, most of the 29 respondents said the size of the Fed’s balance sheet “does not currently pose a problem for the growth or financial stability of the U.S. economy.”
Beyond those issues, the broader debt dynamics could make it even tougher as Warsh takes over. The Congressional Budget Office estimates a federal deficit equal to 5.8% of gross domestic product for fiscal year 2026 versus a 50-year average of 3.8%, with rising interest costs driving it higher.
Research from the St. Louis Fed also concluded that U.S. Treasuries and bonds from some other “risk-free” nations are losing their rate advantage. The study by YiLi Chien, an economist and senior policy advisor at the regional Fed bank, and Kevin Bloodworth, a research associate there, found that as the U.S. central bank began shrinking its balance sheet in 2022, the convenience yield fell around 40 basis points, meaning the U.S. had to pay investors that much more for its borrowing.
Warsh would have to figure out how to counteract that effect to shrink holdings further or explain it as the cost of large deficits, something that would put him close to the sort of “mission creep” into fiscal affairs he has criticized.
Jeffrey Lacker, who ran the Richmond Fed during Warsh’s time as a Fed governor, said Warsh’s balance sheet commentary “resonates strongly” with those wanting a more restrained type of central banking, but that it will take discipline beyond the Fed’s own offices.
“I think for the Fed to back away from things that amount to debt management would clarify market participants’ expectations and would help make the Treasury market more resilient,” Lacker said. It would also “aid in sort of the general process of the Treasury as it has to … face the music in essence.”
(Reporting by Howard Schneider; Additional reporting by Ann Saphir;Editing by Dan Burns and Paul Simao)
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