Reading this on Krawl? Register for free.
Unlock listen-aloud, reading history and personalised feeds — at zero cost.
Free registration unlocks the full Finance Desk
Shrinking the Fed's Balance Sheet: A Path to Price Stability
The Federal Reserve's expanding balance sheet is fueling inflation, distorting markets, and hindering innovation. Critics advocate for a strategic reduction to foster price stability and improve market efficiency.
The Fed's Expanding Footprint
A growing consensus suggests the Federal Reserve's increasing influence and expanding balance sheet contribute to inflation, market distortions, and reduced innovation. The institution's current scale, including its substantial payroll of government economists and a USD 6.8 trillion balance sheet—one-third larger than JPMorgan's—reflects a significant overreach. This expansion, seen as a mission creep, grants the Fed excessive power and a misleading aura of success.
Fed Governor Michael Barr has challenged the idea that a larger Fed ensures market resilience, arguing instead that its massive balance sheet puts the government in control of bond and interbank markets, thereby stifling innovation. Historically, the Fed's fiscal policies have led to significant losses on bond bets, disrupting interbank markets and devaluing the dollar.
Calls for Balance Sheet Contraction
Chairman Kevin Warsh has advocated for fundamental regime change, including shrinking the Fed's balance sheet to enhance price signals and foster competitive markets. This stance is supported by Treasury Secretary Scott Bessent, who highlights how central bank policies exacerbate affordability issues and income inequality. Trillions of dollars injected during the 2010s and the Biden administration were channeled into long-duration bonds, often at the expense of small businesses and working capital.
The Fed's expanded powers during the 2008 financial crisis allowed it to purchase bonds without limit and pay interest, injecting capital into a market already distorted by fiscal policy. These actions, combined with low interest rates and quantitative easing, led to national debt expansion and significant swings in inflation and deflation. Regulatory policies also contributed to bank failures like Silicon Valley Bank.
The pre-Warsh Fed policy aimed for balance sheet expansion, not contraction. Banks were encouraged to borrow more to hold "ample reserves"—trillions in interest-bearing loans that the Fed maintains to avert market volatility. This ample-reserve policy directly opposes the reforms championed by former President Trump's administration, which argued that a larger Fed hinders growth; the evidence suggests the opposite.
Resistance and Reform
Chairman Kevin Warsh faces internal resistance to these reforms from colleagues keen on protecting their current roles. Reducing the balance sheet would set the stage for lower interest rates. Banks could then innovate to meet liquidity needs, rather than relying on the Fed for reserves. This shift would provide more options and reduce the Fed's market dominance.
Extricating the Fed from direct fiscal policy would allow it to concentrate on price stability, countering the confusing promise of ample reserves. A change in balance sheet direction would boost market confidence, increase the long-term value of the dollar, and establish a clear path to price stability and lower bond yields.
The Fed's monopoly on intraday bank liquidity stifles private-sector market growth and innovation. Interbank and repo markets are currently stunted, with the Fed struggling to implement blockchain technology for faster settlements and payment systems. The rise of dollar-backed stablecoins could significantly benefit a Fed that prioritizes market competition, especially with rapid advancements in digital payments from China.
To achieve a smaller Fed that fosters market innovation, Mr. Warsh must overcome entrenched resistance. His substantial credibility is challenged by vocal opposition within the 19-member Federal Open Market Committee, where an inertia-driven governing body is likely to resist new ideas and deny alternatives to the Fed's massive balance sheet.
The Broader Impact of a Smaller Fed
Academic institutions, media, and Wall Street typically advocate for reforms limited to reducing emphasis on forward guidance. This approach would undermine calls for deep reform and efforts to rebuild manufacturing jobs and supply chains.
The Fed's balance-sheet expansion has been particularly detrimental during recent supply shocks. Rapid innovation in the supply chain requires working capital for equipment, inventory, and new hires. However, the Fed's policy of extending excessive bank loans to purchase US Treasuries crowds out small businesses. While it is impossible to erase the damage from previous administrations' inflationary and regulatory policies, a commitment from the Fed to shrink its balance sheet would be pro-growth, pro-dollar, and bond-friendly, leading to wage gains.
David Malpass served as an Under Secretary of the Treasury (2017-19) and President of the World Bank (2019-23). He is Vice Chairman of American Global Strategies and a distinguished fellow at Purdue University.
Found this useful? Share it!
Interested in Finance Education?
Explore our CFA and investing courses — built for serious learners.
