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

It then moved sideways before crawling up to around $3 trillion by 2013, a period that also took in the European financial crisis. It continued rising into 2016, reaching $4.5 trillion, between six and seven times its level when Warsh first joined the board.

Fed Balance Sheet, 2016–2026

From there it declined, falling to $3.8 trillion by 2019, just before the pandemic. The pandemic then triggered a dramatic expansion: the balance sheet rose from $3.8 trillion to $7 trillion in the first year alone, peaking at $9 trillion in 2022, around twelve times its level when Warsh first joined. Since then the Fed balance sheet has declined, falling from $9 trillion in 2022 to about $6.5 trillion at the start of this year. This year, though, it's been climbing again, back up to around $6.7 trillion.

The issue is that this expansion amounts to quantitative easing, genuine stimulus to the economy. So the question Warsh appears to be posing is this: to tighten monetary policy, should the Fed raise the Fed Funds rate, or should it instead pursue quantitative tightening, letting the asset base run down?

In practice, quantitative tightening works like this: as banks buy more Treasury bills and bonds from the Fed, the proportion of their assets allocated to corporate bonds declines, meaning less money flows to the corporate sector. That's how quantitative tightening is generated.

The other strand of what Warsh is doing is improving the Fed's information systems and drawing more insight from financial markets. The Fed should be learning about the economy from financial markets. Financial markets should not be learning from the Fed.

What I think he's also signalling is that the Fed could return more of its debt to financial markets through quantitative tightening, rather than raising the Fed Funds rate in this cycle.