The Fed's "downsizing" dilemma: Top economists outline a balance sheet reduction roadmap for Waller, with reforms potentially taking up to 5 years

Fed nominee Kevin Warsh has previously stated that he hopes to significantly reduce the Federal Reserve’s $6.6 trillion balance sheet; meanwhile, a top financial economist has said it may take more than one term to accomplish this. Stanford Graduate School of Business professor and long-term Fed advisor Darrell Duffie pointed out in a new paper that if the Fed wants to reduce its influence on financial markets substantially without causing severe stress, reforms are needed, including a complete overhaul of bank liquidity requirements and redesigning the payment system.

Once Warsh is confirmed by the U.S. Senate and receives support from colleagues, he could implement some reforms immediately. Duffie said that other reforms might take up to five years, meaning the work could extend beyond Warsh’s four-year term as chair.

“This is akin to transforming the world’s largest payment system,” Duffie said during a Monday conference call with reporters when discussing one of the measures he proposed. “You can’t just write a few lines of code and plug them into the system expecting it to work properly. It requires extensive testing.”

In a paper published Wednesday by the Brookings Institution, Duffie outlined four recommendations the Fed could adopt to reduce banks’ reliance on cash reserves held in central bank accounts. Currently, banks hold about $3 trillion at the Fed, partly due to liquidity regulations implemented after the 2008 financial crisis. Fed officials have welcomed this arrangement because it also provides a simpler way to control short-term interest rates.

During the search for a new Fed chair, Trump indicated that whether interest rates could be lowered immediately would be a key factor in his decision. Warsh, who ultimately was chosen, believes reducing the Fed’s balance sheet would pave the way for rate cuts, though he did not specify how he would achieve this.

Trump’s appointees, Vice Chair for Supervision Michelle Bowman and Treasury Secretary Steven Mnuchin, also proposed reducing liquidity requirements to lower reserve demands. Nonetheless, investors and Fed watchers remain uncertain about how everything will ultimately unfold. Duffie’s paper offers a roadmap.

First, the New York Fed could rely more on temporary open market operations, a tool it has used extensively in the past. According to Duffie, this would be the simplest way to smooth reserve demand fluctuations and could be implemented within a few weeks.

Next, liquidity regulations and measures could be adjusted. Duffie said these changes might take several months to complete. Additionally, clear communication with regulators is essential to prevent banks from being penalized for using tools like the discount window. Although the discount window has been encouraged in financial markets, it has historically carried a stigma.

The Fed could also choose to pay lower interest on reserve balances that exceed certain targets or quotas. Duffie noted that these measures could be implemented quickly, but reaching broad consensus on their design and communication might take years.

Finally, the Fed could emulate other central banks, such as the Reserve Bank of New Zealand, by introducing liquidity-saving mechanisms into its payment system. However, Duffie said this would require changes not only from the Fed but also from commercial banks, potentially taking up to five years.

“Unless you reduce the demand for reserves, you can’t do much,” Duffie said when discussing Warsh’s desire to shrink the Fed’s balance sheet. “You could adopt one or two of these measures first, which might have some effect,” referring to the four proposals Warsh put forward. “But if you want a significant impact, it will require considerable effort.”