Kevin Warsh's quiet plan to shrink the Fed balance sheet

Today, we had the second meeting of the Federal Reserve overseen as Fed Chair by Kevin Warsh. The result of this meeting was that the Fed left the effective Fed Funds rate unchanged at 3.6%. Still, three of the twelve members of the Federal Open Market Committee voted for a rate hike.

Warsh talked about building the Fed's information systems, saying the Fed can learn more from markets, particularly the bond market, than the bond market can learn from the Fed.

Bond markets react to real time events, so it's the Fed that should be learning from the bond market, not the other way around. He referred to the bond market as "a very accomplished economist," very familiar with the internals of financial markets.

Warsh said the Fed is looking closely at its sources of data, not just the data it has, but the data it wishes it had. He said financial markets are a very good source of information.

He also touched on bond yields rising, suggesting this wasn't down to rising inflation but to strong investment in the US economy. That's what's been happening today.

What we want to look at is the longer term strategy Kevin Warsh has brought to the Federal Reserve. For a number of years, Warsh has argued that the Fed needs to reduce the size of its balance sheet. He believes the balance sheet's size, and the Fed's record of financing a large share of government activity, effectively acts as a permission slip for more government spending.

If there was downward pressure on the balance sheet, he argues, there would be more fiscal discipline in government, and the debt to GDP ratio in the US would start to decline instead of continuing to rise.

To illustrate this, we're showing a couple of charts from the Federal Reserve database on the history of the Fed's balance sheet.

Fed Balance Sheet, 2004–2016

The first chart covers 2004 to 2016. This is a period when a lot happened. The shaded area on the left marks the Global Financial Crisis of 2007 to 08. Kevin Warsh joined the Federal Reserve Board in 2006, having previously worked at the White House, and served at the Fed until 2011, so he was there right through the crisis.

When he joined, the Fed balance sheet stood at around $0.78 trillion (US$780 billion), the lowest level it would reach over the period we're covering. During the financial crisis, in order to recapitalise US banks, the balance sheet expanded rapidly from $0.78 trillion to $2 trillion.