Jai Kedia and Norbert J. Michel
Arguments over the Fed’s bloated balance sheet are likely to take center stage under new Fed Chairman Kevin Warsh’s leadership. Warsh has already signaled that he wants to shrink the balance sheet and, therefore, the Fed’s footprint in financial markets, but he is certain to face stiff resistance from both inside and outside the Fed.
The current operating framework, with its massive balance sheet, was first implemented to enable the Fed to make large-scale asset purchases during the 2008 financial crisis. But the crisis-era framework was never undone, and it has become deeply entrenched at the Fed. As a result, the Fed has a much bigger footprint in the financial system and has effectively taken over the interbank lending market for reserves—something that should be determined optimally between banks in a free market.
Before the 2008 financial crisis, the US had a healthy interbank market for reserves. Daily trading fell from around 2 percent of US commercial banking assets to just half a percent post-crisis—and even that residual volume is mostly arbitrage by government-sponsored enterprises and foreign bank branches, not banks trading reserves with one another. It is true that the pre-2008 interbank lending system was not a fully free market; such a market cannot be achieved in a system with a centralized fiat currency and an intervening central bank.
But the system was far superior to our current one, where banks are overrun with reserves because the Fed avoided intervening too heavily in the market for reserves. A private lending market provides accurate, real-time market signals and discipline that the current system cannot. It is also more consistent with the Fed’s role as a lender of last resort. Instead, the current system treats the Fed as a buyer and lender of any resort.
While supporters of the current framework argue it makes it easier for the Fed to implement monetary policy, the truth is that it merely makes it easier for the Fed to maintain a target federal funds rate because the federal funds market is so dormant. Moreover, there is little reason to believe that monetary policy is more effective under this framework than under the previous one. In fact, the pre-2008 system coincided with the Great Moderation—a period with low and stable inflation and unemployment—while the post-2008 system coincided with a prolonged recovery period and, more recently, above-average inflation. The Fed routinely praises the conduct of monetary policy in the pre-2008 era despite modern central banking drifting far from that period’s good policymaking.
So far, most discussions around the best approach to the balance sheet keep the Fed as the hub of the banking system’s liquidity. These approaches purportedly address the problem from the “supply side” or “demand side,” but in either case, they ultimately prevent an interbank borrowing market from existing.
On the supply side are proponents of the present abundant-reserves system. Dallas Fed President Lorie Logan, a prominent defender of the current framework, argues that reserves are essentially costless to produce—“an electronic entry on the central bank’s books”—so efficiency requires supplying enough of them to keep market rates pinned at the IOR floor. But as we have argued before, the cost of a large balance sheet well exceeds the accounting cost of producing reserves. The Fed pays interest on trillions of dollars of reserves—payments that have exceeded its income since 2022 and halted its remittances to the Treasury. And as Bill Nelson of the Bank Policy Institute told Congress, a floor system requires not just a large Fed but an ever-expanding one, since estimates of “ample” only ever ratchet upward.
Demand-side reforms are more prevalent (and already being operationalized) at international central banks. Under this method, the central bank lets its securities run off until reserves become scarce in aggregate. From then on, banks get the reserves they need by borrowing them from the central bank’s standing lending facilities. For example, the Bank of England is transitioning to a “demand-driven, repo-led” framework, and usage of its long-term repo facility has tripled over 2025.
Proponents of this system at least recognize that the central bank’s vast securities holdings are a problem, but their solution moves the federal funds rate from its floor to its ceiling, skipping the interbank market entirely. To be fair, demand-driven systems are an improvement over the status quo: the central bank sheds its securities portfolio. But it is still no substitute for a market-based approach. Loans replace bonds on the asset side, and the ceiling replaces the floor on rate control, but the essential feature survives: every bank’s marginal dollar of liquidity comes from the Fed, not from another bank.
The best case is for the Fed to methodically sell off its securities and revert monetary policy to its pre-2008 operating system, as was intended when quantitative easing was first adopted as a temporary measure. Yes, that system would ask more of the Fed, whose trading desk would need daily open market operations to keep the federal funds rate on target. For instance, Logan has complained that the market approach “requires the much heavier lift of actively managing reserve supply on a daily basis.” But the Fed performed this lift precisely, routinely, and successfully for decades before 2008. Regardless, convenience for the Fed’s trading desk is a thin rationale for a multi-trillion-dollar policy regime.
The Warsh chairmanship offers a real chance of finally shrinking the Fed’s bloated balance sheet. While any sustained and systematic curtailment of the balance sheet is desirable, the best solution is to allow banks to trade reserves with each other once more so that the market can provide clear price signals to policymakers and financial market participants alike. This approach is also more consistent with the Fed’s role as a lender of last resort rather than a constant provider of daily liquidity for no particular reason.
The correct approach to Fed reform is a return to a market-based system, not one that requires government interference with either the demand or supply of reserves.
