The payment system puts a floor on the Fed’s balance sheet

If the Federal Reserve wants to shrink its massive balance sheet—as President Trump’s nominee to be the next Fed Chair,  Kevin Warsh, advocates—it must find ways to reduce the demand by banks for reserve deposits at the Fed or risk severe disruptions to money markets, according to a paper to be discussed at the Brookings Papers on Economic Activity (BPEA) conference on March 26.

On the asset side of its balance sheet ($6.6 trillion in mid-March), the Fed holds mainly Treasury securities and government-guaranteed mortgage-backed securities. The Fed’s largest liability is in the form of reserve balances, currently totaling about $3 trillion. These are deposits held at the Fed by banks. The Fed controls short-term interest rates primarily through the interest rate it pays on those balances.

“If the Fed were to significantly reduce the size of its balance sheet, the supply of reserve balances would need to be reduced by about the same amount,” writes the paper’s author, Darrell Duffie of Stanford University.

Advocates of a large balance sheet argue that the resulting ample supply of reserves allows the Fed to easily control short-term interest rates. But critics maintain it is not economically healthy for the Fed to dominate money markets and that the Fed’s Treasury securities holdings create the perception that the Fed is helping to finance the federal deficit.

“You don’t want the Fed to smother the financial system but if you were to immediately make the balance sheet much smaller, you will blow up money markets. Nobody wants that,” the paper’s author, Duffie said in an interview with the Brookings Institution.

Before the 2007-2009 Global Financial Crisis, the Fed’s balance sheet was less than $900 billion. It ballooned to more than $4.5 trillion as the Fed purchased securities, at first to calm financial markets and then to support the economy by lowering longer-term interest rates. The Fed began to shrink its balance sheet in 2014 but ran into trouble in September 2019 when interest rates spiked because banks were reluctant to lend reserves to money-market participants.

The Fed again expanded its balance sheet (to nearly $9 trillion in 2022) to support markets and the economy during the COVID-19 pandemic. And, again, the Fed reduced its  balance sheet until late last year, after money market strains emerged from an apparent shortage of reserves.

Post-Global Financial Crisis liquidity regulations that require banks to prove they would not need to borrow from the Fed under almost all circumstances explain much of banks’ preference for maintaining high reserve levels. Also, before the crisis, the Fed did not pay interest on reserve balances so banks had a strong incentive to lend balances they did not need.

If the Fed decides to reduce its balance sheet, Duffie’s BPEA paper explores four approaches for doing this. First, the Fed could revise its liquidity regulations so that banks feel less pressured to conserve their reserve balances. Second, it could change the operations of Fedwire (the Fed’s largest payment system) so that banks could make their outgoing payments with incoming payments and thus need fewer reserves at the start of each day. Third, the Fed could tier interest rates on reserves, paying a lower interest rate on reserve balances beyond a specified target or quota, thus giving banks a strong incentive to lend these extra balances. And, fourth, the Fed could smooth the path of reserves by offsetting unintended shocks to the supply of reserve balances, for example those that occur at the end of each quarter.

“Any of these changes could have a moderate or large effect on the total demand for reserves. In combination, their effects on the total size of the Fed’s balance sheet could be quite significant,” Duffie said in the interview.

However, he noted that if the Fed ends up holding fewer long-term Treasury securities (thus placing more of them with private holders), then the federal government would probably need to pay a slightly higher average interest rate on its debt.