Rule changes may only yield modest Fed balance sheet contraction

By Michael S. Derby

NEW YORK, May 29 (Reuters) - Some people inside and outside the Federal Reserve agree that rule changes easing how much cash banks need to keep on hand for emergencies could allow the central bank to further cut the size of its $6.7 trillion balance sheet but also harbor doubts holdings could be slashed by the degree new Chairman Kevin Warsh desires.

By one bank's estimate, regulatory changes might cut reserve demand by more than a fifth from its current trend level, though a key Fed insider doubts it would yield even that.

Discussion around the size of the Fed's balance sheet has intensified with the arrival of Warsh to succeed former Chair Jerome Powell, and it looms large on the agenda of a reform-minded central bank leader.

The new chief was a Fed governor through the 2007-2009 financial crisis that gave birth to the modern Fed's hefty stash of bond holdings. While he never formally dissented with either the initial expansion of the balance sheet or its continued use as a policy lever afterward, his resignation from the board in 2011 was widely viewed as linked to his well-known aversion to the quantitative easing program.

BNP Paribas analysts said in a new note that a suite of rule changes that would take time to implement would likely allow bank demand for reserves, currently standing at $3.1 trillion, to shrink by around $700 billion.

Lower reserve demand could be achieved by letting banks' discount window lending capacity at the Fed count toward liquidity requirements, the introduction of central clearing for Fed repo operations and upgrading agency and mortgage bond debt to the highest quality rating, the economists wrote.

Some also believe more active usage of Fed repo operations, which lend cash on demand, would allow banks to hold lower levels of emergency funds.

DEBATE STAGE SET

Still, skepticism runs deep among some key Fed policymakers that it's possible to return to the kind of lean balance sheet the Fed maintained prior to the financial crisis, setting the stage for a lengthy debate ahead.

"There's no way you can go back to the small balance sheet we had" in the years leading up to the financial crisis nearly two decades ago given the current configuration of the financial system, Fed Governor Christopher Waller said last week.

That said, he acknowledged the Fed is looking at ways it could change rules governing the reserves held by financial institutions and that could lead to a smaller balance sheet over time.

Regulatory tweaks could allow reserves to ebb by between $300 billion and $500 billion, but even so, with those possible changes "you're talking about a balance sheet of over $6 trillion...It's just not likely to go down very much," Waller said.

Warsh's long criticism of the Fed's balance sheet size is rooted in a belief that it distorts markets and impedes the central bank's ability to use its policy interest rate as its main tool for influencing the economy.

First in the financial crisis and then again in the COVID-19 pandemic the Fed aggressively purchased Treasury and mortgage bonds to steady markets and bolster the stimulative power of monetary policy. Those campaigns took Fed holdings from under a trillion dollars in 2007 to a peak of $9 trillion by the summer of 2022, amid a large-scale change in the toolkit the Fed uses to manage short-term interest rates.

From 2022, the Fed drew down its holdings as part of a broader tightening in monetary policy and got them to $6.5 trillion by the end of 2025 before growing them again in a technical bid to bolster liquidity to ensure firm control over its interest rate target.

Under the current system, there are limits to how far the Fed can drain liquidity from the financial system and keep control of its interest rate target.

Over recent months Fed officials and outside academics have been sketching out possible options for achieving Warsh's balance sheet goals, amid some worry that easing liquidity regulations, at a time when the Fed is broadly scaling back on bank oversight work, will create notable financial stability risks.

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