Kevin Warsh’s real regime change may take place deep in the Wall Street pipeline

Incoming Federal Reserve Chairman Kevin Warsh’s speech about a “regime change” at the central bank has sparked speculation about everything from interest rates to major staff changes to fundamental changes in the way it operates and communicates.

But what could end up looking subtle or perhaps even more important is a rethinking of the way the Fed manages the financial pipeline to the American economy and the massive balance sheet it has built up over 18 years of crisis fighting.

Interviews with former Fed officials and economists, as well as a growing library, suggest that Warsh could steer the Fed to a smaller role in day-to-day financial markets, while also setting clear rules on how and when to intervene.

Simply put, the debate centers on whether the Fed should continue to use its balance sheet as a general tool to influence financial conditions and supporting markets – as it has done for much of the post-financial crisis period – or reserve it for periods of market dysfunction and dangerous economic stress.

The debate over the $6.8 trillion balance sheet is technical in nature and far removed from more general discussions about Fed policy. But the risks are great.

Since the financial crisis in 2008, the Fed has aggressively used its Treasurys and mortgage-backed securities to stabilize markets and influence broader financial conditions.

Before the crisis, the Fed had a relatively small balance sheet – about $800 billion – but it expanded at one time to about $9 trillion. Fed assets are now equal to 23% of the US economy, or seven times where they were before the financial crisis.

Any attempt to change the system could have far-reaching consequences, potentially affecting Treasury maturities, mortgage rates and other interest-sensitive areas of the economy, while influencing how policymakers respond to future crises.

“It’s a debate we’ll see later this year. But the encouraging thing about all of this is that no one, including Kevin Warsh, is arguing that any of this can be done quickly,” said Lou Crandall, an economist at Wrightson ICAP and a longtime Fed watcher.

“It has to be done carefully, and some of the changes … may take some time to implement,” he added. “Everyone is looking at this as a medium-term project rather than part of a one-day agenda.”

Warsh called the balance sheet, in a Wall Steet Journal op-ed piece last year, “bloated” and said it could be reduced while simultaneously allowing the Fed to lower interest rates.

While Warsh has talked extensively about reducing the Fed’s footprint, Wall Street is already toying with what the new operating framework might look like.

Among the provocative ideas comes from the chief economist of TS Lombard in the US, Steve Blitz, who says that the Warsh Fed can put more weight on the overnight repo market – a short-term funding system that supports the Treasury’s market activity – rather than relying only on the government’s monetary balance – banks charge each other as an important means of borrowing overnight.

“The repo rate becomes the policy rate,” Blitz said in a client note.

In practice, that could create an unusual dynamic: Warsh might be able to satisfy Trump’s push for lower interest rates while maintaining tight monetary conditions as policymakers grapple with continued inflationary pressures.

However, he is likely to face immediate opposition from fellow policymakers, some of whom question the Fed’s ability to significantly reduce its holdings and the benefits this could provide.

“I think that reducing the balance sheet is the wrong goal, and many proposals to meet this goal will undermine the stability of banks, hinder the functioning of financial markets, and, ultimately, endanger financial stability,” said Treasury Governor Michael Barr in a speech last week. “In fact some will expand the Fed’s foothold in the financial markets.”

Barr’s thesis is actually that looking only at the size of the balance sheet is too small – that other issues, such as how they are integrated in relation to duration and composition are also important. Ignoring those issues, he says, could have “perverse” effects such as increased volatility and the possibility of more intervention from the Fed. At the same time, he said that reducing the requirements for depositing money in banks may disrupt the system.

Balance sheet mechanics in relation to reserves are straightforward.

When building the balance sheet, the Fed awards itself digital currency and uses it to buy assets from banks, creating reserves. That gives banks liquidity which in theory flows through the financial system. Conversely, when the Fed shrinks its balance sheet, it stops buying assets while also allowing the proceeds of the bonds it bought to be rolled over, rather than reinvested.

On the other side of the job, the Fed uses its trading desk to achieve its interest rate target. The central bank also has a number of other tools, such as the interest it pays on reserves, its discount window rate and, most importantly, overnight reverse repurchase operations that keep money flowing.

The Fed has been operating under an “adequate” reserves system, an unusual term that means more than normal but not excessive – which would be “excess.” Warsh indicated that the Fed could return to its policy of “rare” monetary policy, with the option to increase it if needed.

“Reasonable people would argue against this,” said Bill English, the Fed’s former monetary policy chief and now a professor at Yale. “The Fed can go back to a system with scarce reserves, it can be very efficient. It might be hard to get there. You’d want to do it a little bit, but I think they can do it.”

After spending much of the past 18 years depending on the Fed’s balance sheet to maintain efficiency — and, critics would argue, supporting the bull run on stocks — markets will be watching closely.

“I would very much expect the Fed to have an open discussion about establishing a framework for future actions, so that the market doesn’t just assume they’re going to do unlimited rates,” said Wrightson economist Crandall. Doing so “will allow the market to make reasonable expectations about what will happen.”

As things stand, the Fed has never communicated clear rules about when and how the balance will be used.

Markets have embraced the principles of balance sheet operations – quantitative easing, or QE, for expansion and quantitative easing, or QT, for reduction – but the Fed has never set clear guidance on when or where to use them. That is especially true when you distinguish between talking about the performance of the financial market and supporting its twin goals of inflation and employment.

“They never really set a framework for when to use quantitative easing,” said former Cleveland Fed President Loretta Mester. “The Fed hasn’t done a very good job, I think, over time of separating and explaining when it uses asset purchases for a monetary policy reason.”

This is where Warsh in particular can fit in.

Setting the tone for policy guidance is well within the chair’s wheelhouse, and Warsh may try to dampen market expectations that the Fed will increase asset purchases if Wall Street starts to get the jitters.

In addition, he spoke in favor of efforts by Michelle Bowman, the Fed’s vice chair for banking supervision, to ease some banking regulations. Part of that would be changing what types of assets banks can seek as reserves and use in times of crisis, an effort Dallas Fed President Lorie Logan said in a recent speech, saying she’s looking forward to “seeing how that work goes.”

Logan has firsthand experience with the dynamics that go into balance sheet management. Prior to his current position, he headed the trading desk at the New York Fed, charged with implementing the central bank’s open market strategy.

Logan also noted, in a speech given on April 2, that the Fed has other tools to help the flow of money – in fact, it uses parts from both sides of the Warsh and Barr argument.

Like others, he recommended moving slowly to fix the problem.

“I would stress that any changes to the balance sheet should be gradual and carefully planned,” said Logan.

Inside, Fed officials are belting out the debate.

Central bank researchers have released several papers on the matter, including one titled “A User’s Guide to Shrinking the Federal Reserve’s Balance Sheet.”

The paper concludes, without consensus in either direction, that $2.1 trillion in reductions could be achieved with the current policy framework, and further reductions if the Fed changed its approach to keeping scarce money in the bank. The paper also says it will take “at least a year and possibly several” before the process begins.

All of these proposals are likely to be on the table after Warsh takes office on Friday.

He inherits a Fed facing not only economic challenges but also high political expectations from a president who regularly attacked outgoing Chairman Jerome Powell, branding him “Too Late” as he also threatened to fire him for failing to deliver on Trump’s desire for lower rates.

For all the talk about “regime reform,” former officials caution against expecting dramatic overnight changes, with Warsh’s lofty goals about to meet the central bank’s reality.

Warsh will inherit a Federal Open Market Committee built on consensus, where even major policy changes are often deliberate and only after lengthy internal debate. These officials say that political views remain outside the walls of the state bank.

“I used to go to the FOMC meetings there [Alan] Greenspan was the chairman, so for a long time. Politics don’t come into that room,” said Mester, a former president of the Cleveland Fed. “Politics doesn’t come into the conversation.”