Brookings Institution paper charts path toward smaller Fed balance sheet

March 25 (Reuters) - If the Federal Reserve truly wants a smaller balance sheet, it can get there with regulatory changes, tweaks to the payment system and more frequent market interventions by the central bank, new research published by the Brookings Institution said on Wednesday.

In a paper written by Darrell Duffie, professor of management and professor of finance at the Stanford University Graduate School of Business, the academic sketched out a complex path that would take some time to achieve. Duffie wrote that the key focus of any move to reduce the overall size of the Fed balance sheet comes down to reducing the market's still very strong appetite for reserves.

To temper that appetite, Duffie wrote liquidity rules could be relaxed to make financial firms more comfortable with keeping less liquidity on hand. The central bank's Fedwire payment system could be changed to more closely link firms' incoming and outgoing payments, further reducing the need to keep excess cash on hand.

The Fed could also change the rate it pays to financial firms and lower it for reserves beyond a given level. And finally, the Fed could use temporary liquidity injections, called temporary open market operations, more frequently, as opposed to the current system that puts that type of liquidity management largely on autopilot.

"I'm not taking a stand on whether the Fed should reduce its balance sheet," Duffie told reporters in a virtual meeting. "That's a big cost-benefit analysis that I'm leaving up to the Fed."

But he noted "the benefits of a large balance sheet are quite tangible" and having a system flush with liquidity brings financial stability benefits and has worked well for the Fed's monetary policy mission.

"The costs are more intangible and sometimes verge into politics," as some worry about how large Fed holdings can affect Fed independence, among other concerns, Duffie said.

REGIME CHANGE

Duffie's work to map out a path toward smaller Fed holdings comes as Kevin Warsh, a staunch critic of a large Fed balance sheet, has been tapped to succeed current Fed Chair Jerome Powell when his leadership term ends in May. Treasury Secretary Scott Bessent has also been critical of a large Fed footprint in asset markets.

Big Fed holdings are the product of economic crisis and the Fed's response to those events.

The size of the Fed's balance sheet has risen from just under $1 trillion just before the onset of the financial crisis in 2008 to a current level of $6.6 trillion, which is down from the $9 trillion peak hit in 2022.

Fed holdings swelled over several episodes in which the Fed aggressively bought Treasury and mortgage bonds to smooth dysfunctional markets and to provide economic stimulus beyond what could be delivered by the Fed's traditional tool to achieve its goal, which is changes in short-term rates.

The side effect of bond buying has been a massive increase in bank reserves, as firms that sold bonds to the central bank were credited with Fed-generated cash. At the same time, post-crisis regulatory systems have driven banks to hold reserves.

To manage short-term interest rate levels, the Fed has developed a suite of tools that have delivered strong control of the federal funds rate, the Fed's main monetary policy tool.

The challenge for the Fed is that if too much liquidity is taken out of the system, the Fed loses control of short-term interest rates. That happened in 2019 when the Fed was allowing bonds it owned to mature and not be replaced, in a bid to cut the size of holdings, and was about to happen late last year.

After drawing down the balance sheet from 2022 onward, since December the Fed has been aggressively buying Treasury bills to rebuild liquidity through the tax season, in what it billed as a purely technical operation.

It is widely expected to slow those purchases once May rolls around.

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(Reporting by Michael S. Derby; Editing by Andrea Ricci )