Kevin Warsh

Financial markets welcomed the nomination of Kevin Warsh to succeed Jerome Powell as chair of the US Federal Reserve, and it is easy to see why. Warsh is neither a Maga ( Make America Great Again ) ideologue nor an inflation alarmist. He is a seasoned policymaker who operates according to a clear analytical framework, shaped by his work at the Fed during the 2008 global financial crisis, and he views bureaucratic excess with healthy scepticism. But while Warsh has experience and a degree of intellectual rigor in his favour, he is at risk of making a critical mistake when he assumes the helm.

Warsh is right about one thing: interest rates should remain the Fed’s primary monetary-policy instrument. Price-based monetary policy is transparent, flexible and well understood. By contrast, large-scale asset purchases and balance-sheet manipulation are blunt tools that risk distorting markets and entangling central banks in quasi-fiscal decisions.

Warsh might also be right that US inflation risks are currently lower than conventional models would suggest, owing to an emerging productivity boom. Former Fed chair Alan Greenspan made a similar assessment in the 1990s, when rapid productivity growth – fuelled by the internet revolution – surprised Fed staff, who consistently overestimated inflationary pressures.

But when it comes to a third key conviction – that the Fed should substantially shrink its balance sheet – Warsh’s analytical clarity gives way to institutional nostalgia. In fact, the large size of the central bank’s balance sheet is not a discretionary policy choice, let alone a consequence of excess. Rather, it reflects structural shifts in the financial system, relating to how liquidity is demanded, regulated, and supplied.

Since the 2008 crisis, banks’ demand for central-bank reserves has permanently increased. Post-crisis liquidity regulations – most notably, the liquidity coverage ratio standard established by the Basel Committee on Banking Supervision – have classified reserves as the highest-quality liquid asset in the system.

At the same time, the private sector’s capacity to intermediate risk has declined. With tighter leverage constraints and changes in market structure having shrunk dealer balance sheets, particularly in US treasury markets, central banks have increasingly replaced private intermediaries as the marginal providers of market liquidity.

The massive size of US government debt and the changing composition of its investor base must also be considered. Treasury issuance has grown structurally, and an increasing share of these bonds are now absorbed by non-bank financial institutions – money market funds, hedge funds and other leveraged investors – whose demand for liquidity is inherently pro-cyclical. In this context, the Fed’s balance sheet plays an essential stabilizing role.

Rather than merely conducting monetary policy, the Fed is now underwriting the liquidity of the world’s most important sovereign-debt market. Its large balance sheet is thus not an ideological preference, but an operational necessity, which cannot simply be abandoned.

This much was clear when the Fed attempted to tighten liquidity conditions in 2018-19. Money markets were put under immediate strain, which culminated in a surge in interest rates on overnight repo transactions in September 2019. Since then, even modest balance sheet reductions have coincided with volatility in treasury markets. These episodes suggest that the private sector’s capacity to absorb liquidity shocks remains limited, particularly when non-bank investors are forced to deleverage.

In theory, the financial system’s post-2008 evolution could be reversed. But reducing banks’ structural demand for reserves would require far-reaching deregulation of the banking sector, including loosening liquidity requirements and leverage constraints, as well as a willingness to accept greater volatility in sovereign-debt markets, with dealer balance sheets again serving as the primary shock absorbers. Even then, it is unclear whether private intermediation could reliably support a treasury market of today’s scale.

In fact, there is good reason to think that a determined effort to shrink the Fed’s balance sheet would result in more central-bank intervention. As private balance sheets were put under strain and market liquidity declined, episodes of stress would become more frequent, forcing the Fed to intervene through standing facilities, ad hoc liquidity operations or emergency lending. Balance sheet reduction would thus follow a bumpy, stop-and-go path, punctuated by reversals that risk undermining the Fed’s credibility.

Such a strategy would also strain relations among global regulators. The post-crisis financial system rests on a fragile international consensus about liquidity standards, dollar funding backstops, and central bank cooperation.

A US-led push to deregulate bank liquidity while shrinking the Fed’s balance sheet would not sit well with foreign regulators who remember well the global dollar shortages of 2008, 2020 and 2023. The result could be greater regulatory fragmentation, renewed frictions in cross-border dollar funding markets and heavier reliance on bilateral swap lines in moments of stress.

Fortunately for Warsh, a large balance sheet does not, by itself, imply inflationary risk. Because the Fed pays interest on reserves, it can expand them without pushing down market interest rates or encouraging excessive credit creation. Reserves are not money in circulation; they are a settlement asset used within the banking system. As long as the policy rate is set appropriately, the Fed can supply liquidity at very low marginal cost, while maintaining control over inflation.

One hopes that, by the time he takes over in May, Warsh comes to realize that the Fed’s balance sheet is no longer merely a policy lever; it has become part of the financial system’s core infrastructure. Shrinking it substantially would require a wholesale redesign of financial regulation and a higher tolerance for instability in both banking and sovereign debt markets. The decision facing Warsh’s Fed is not whether to restore monetary orthodoxy, but rather how much risk society is willing to bear in exchange for a smaller central bank footprint.

Lucrezia Reichlin is a professor of economics at the London Business School and a former director of research at the European Central Bank.

Copyright: Project Syndicate