THE LARGE BALANCE SHEET IS COSTLY REGARDLESS OF WHAT THE FED CLAIMS

The following information was released by the Cato Institute:

Norbert J. Michel and Jai Kedia

New Fed Chairman Kevin Warsh has committed publicly to reducing the Fed's financial footprint and reverting its balance sheet to a sensible size. This is a worthy goal that should be paired with Congress ending the Fed's ability to pay interest on reserves (IOR). These reforms are critical for shrinking the Fed's footprint in financial markets and for maintaining a clear line between monetary and fiscal policy.

The latter of these benefits, maintaining a clear line between fiscal and monetary policy, is often ignored in this debate, especially by those who oppose shrinking the balance sheet and ending IOR. In fact, Warsh will face resistance by some members of the Federal Open Market Committee who mistakenly argue that maintaining a large balance sheet and the IOR framework are necessary and costless. This claim is based on faulty arguments that wrongly attribute certain benefits to the current policy regime and ignore its true economic cost.

Large Balance Sheet Supporters Are Mistaken

In February 2025, at the Bank of England, Dallas Fed President Lorie Logan gave a speech that justified maintaining the Fed's existing policy regime. The speech framed this decision as one that would maintain an "efficient and effective" balance sheet. (Ironically, the Bank of England has explicitly identified shrinking its balance as necessary to reduce the risk associated with maintaining a larger footprint.) For instance, the speech argues that "the central bank's marginal cost of supplying reserves is typically small," so "efficiency calls for money market rates to land close to the interest rate on reserves."

It is true, of course, that the Fed's cost of adding a dollar of reserves is incredibly small. But that fact is essentially irrelevant to this debate, and it ignores the full economic cost of the current policy regime. It's also dangerously close to suggesting that the Fed should use the IOR rate to "set" money market rates wherever it likes, something it cannot accomplish without even greater cost. It also ignores that reserve requirements are a deliberate policy choice (effectively the equivalent of a tax on banks), as was the decision in 1980 to require all banks to hold reserve accounts at the Fed. (Prior to the 1980 Depository Institutions Deregulation and Monetary Control Act, fewer than 40 percent of banks were members of the Federal Reserve System, and the number had been declining.)

Just as important, Logan ignores key elements of the current policy regime that render her arguments circular at best. In particular, she ignores how and why the Fed enlarged its balance sheet in the first place. For instance, Logan's efficiency argument culminates with the following:

While it remains conceptually possible to implement monetary policy today with scarce reserves, developments since the GFC [global financial crisis] would complicate the task of fine-tuning reserve supply to hit a point on the steep portion of the demand curve. Changes in regulations and banks' own risk management have made reserve demand larger, more volatile and more difficult to predict. In the U.S., fiscal flows also create more reserve volatility than previously.

While that's an interesting philosophical discussion, I don't see much of a practical argument for the U.S., at least. When the U.S. banking system has excess reserves, they tend to accumulate at the largest money-center banks. The regulations applicable to such banks disincentivize unsecured lending to other banks. As a result, only very large spreads between money market rates and interest on reserves would likely suffice to revive the U.S. interbank marketand that would be very inefficient.

The biggest problem with this reasoning is that the "developments since the GFC" that "complicate the task of fine-tuning reserve supply" are the Fed's own creation. These developments are the Fed's active decision to make large-scale asset purchases and to ask Congress to accelerate its authority to pay IOR to keep a lid on the new reserves those purchases created. In fact, when Congress originally enacted the IOR authority, hardly anyone (if anyone) contemplated implementing monetary policy with IOR, especially not by paying interest on excess reserves because banks rarely held any.

In July 2025, at the Federal Reserve Bank of Dallas, Fed Governor Chris Waller made a similar self-serving argument to justify the current policy regime. Waller stated that:

...we consciously changed our implementation framework for providing liquidity to the banking system by moving from a scarce-reserves system to an ample-reserves system. This change was necessary because there were shortcomings with the scarce-reserves approachshort-term rates were harder to control and required daily interventions in the markets by the Fed, and these problems were made worse when rates were at or near zero.

The problem, of course, is that these shortcomings existed only because the Fed decided to purchase such large quantities of securities. In his book The Courage to Act, sitting Fed Chairman Ben Bernanke acknowledged that the Fed was "facing what might prove to be a critical question: Could we continue our emergency lending to financial institutions and markets, while at the same time setting short-term interest rates at levels that kept a lid on inflation?" The Fed chose to keep buying more assets and realized that it could use IOR to "keep a lid on inflation," conscious policy decisions that literally made the interbank lending market irrelevant because those purchases flooded the market with reserves. In other words, the change to an abundant-reserves system is what caused the shortcomings with the scarce-reserves approachbanks stopped using the interbank lending market because the Fed injected so many reserves into the system.

This circular reasoning by Logan and Waller would be bad enough, but Logan goes even further by arguing that the current policy regime is more efficient because it simplifies the Fed's ability to influence interest rates. Specifically, Logan argues:

The ample-reserves regime simplifies rate control because fluctuations in reserve supply and demand don't require frequent and precise offsetting central bank actions. You might say this makes the ample-reserves regime efficient for a second reason. Not only does it avoid the inefficiencies associated with a liquidity premium on reserves, but it also saves some forecasting and operational effort. The ample regime requires gradual forecasting and operations to approximately track demand for central bank liabilities over periods of months and years. The scarce-reserves regime requires the much heavier lift of actively managing reserve supply on a daily basis to precisely match demand.

Aside from the strangeness of a member of the Federal Open Market Committee arguing that it's too difficult to conduct open market operations and that her committee should avoid that "heavier lift," this statement also ignores that the Fed does not have precise control over "interest rates" in the first place. Yes, it can administer the IOR rate, but history clearly shows that market rates move in ways the Fed can't stop, especially when monetary policy is severely at odds with private borrowing markets.

Regardless, all the above arguments assume, as do many supporters of the current policy regime, that the IOR framework is a perfect substitute for open market operations, with no additional cost. That view is completely wrong, and even former Fed Chair Ben Bernanke acknowledged the costs of this new regime, including impairing the functioning of securities markets, degrading liquidity and price discovery, reducing the public's confidence that the Fed would reverse its overly accommodative stance, creating more financial instability, and incurring financial losses if interest rates rose. Arguably, each of these costs have already come to fruition. (One major example: In 2023 and 2024, the Fed lost nearly $200 billion paying IORmoney that would have otherwise been remitted to Treasury.)

Bernanke also argued that the hurdle for using the nontraditional policies "should be higher than for traditional policies" because "nontraditional policies have potential costs that may be less relevant for traditional policies." One of the most obvious potential costs is the one that seems to be most often ignored: the risk that the current regime will be used in the funding of backdoor government spending. Simply put, the current policy regime, an abundant-reserves system with IOR, blurs the lines between monetary and fiscal policy. It allows the Fed to purchase as many assets as it would like, all while paying firms to hold on to the excess cash that these purchases create, thus providing a built-in check on inflation. (It's also inaccurate that Treasury securities and reserve balances are interchangeable assets that banks would hold at identical yields and quantities.)

The new regime can allow the Fed to be a pawn of the US Treasury for the simple reason that its asset purchases no longer directly threaten its price-stability mandatethe Fed's operating framework is designed to pay interest on reserves for the express purpose of preventing asset purchases from funding broader money creation. Prior to 2008, the Fed was able to legitimately warn Treasury (or Congress) that such moves would be inflationary. Under the current regime, it can no longer do so. (At least in the short run; in the long run, once enough debt accumulates, it will lead to disastrous consequences as people realize what the government is doing.) As a result, the Fed is more susceptible to pressure for funding all kinds of projects and new borrowing.

Conclusion

Kevin Warsh, the new chairman of the Fed, is committed to reducing its financial footprint and shrinking its balance sheet. Warsh should waste no time implementing a plan to shrink the balance sheet, and Congress should follow up by revoking the Fed's authority to pay interest on reserves (IOR). These reforms would help shrink the Fed's footprint in financial markets and restore a brighter line between monetary and fiscal policy. The Fed's balance sheet should be used for monetary policy, not banking policy or fiscal policy.

This post is cross-posted from Norbert Michel's Substack, Mind the Gap.