Former Fed officials tell Warsh balance-sheet size is the wrong target

Kevin Warsh gets sworn in as Federal Reserve chair on Friday. The first piece of unsolicited advice has already landed. Former Fed officials said Monday the incoming chair ought to worry less about the central bank’s balance-sheet size and more about something harder to measure: whether policy still transmits cleanly through a market priced for higher-for-longer rates. Speaking to Reuters, former governor Jeremy Stein called the balance sheet “an optical political football.” The sharper question, Stein said, is how much liquidity the banking system and money markets actually need. That number is getting harder to pin down, with the federal funds target at 3.5 per cent to 3.75 per cent and investors still split on whether the next move is a cut postponed again or a hike.

The group’s central argument: a $6.7 trillion portfolio figure does not tell markets very much by itself. The balance sheet is already roughly $2 trillion below its pandemic-era peak, Reuters reported, yet the post-crisis operating framework still runs on abundant reserves, deep repo-market liquidity and a Treasury market that has to digest heavy issuance without seizing up. If inflation stays sticky and rates remain high, the next chair is going to need every tool in that framework. Promising to shrink a headline number would be a poor substitute for a plan that explains how policy actually reaches households, banks and bond investors.

Stein’s warning carries more weight than the standard Washington argument about central-bank sprawl. He was not defending permanent crisis settings. His point was narrower: the Fed now operates through a market structure that simply did not exist when its assets sat closer to $800 billion. Charles Evans, the former Chicago Fed president, put it more bluntly in the same Reuters report: “Anyone longing for the good old days of $800 billion is just completely unrealistic.” The shift reflects changes in bank liquidity demand, the layering of post-crisis regulation and the Fed’s own decision to run an ample-reserves regime that keeps overnight rates under control with fewer surprises.

Why the number matters less

Governor Michael Barr’s speech on the balance sheet made the case for caution in institutional language. Balance-sheet decisions, Barr argued, have to support monetary-policy implementation and financial stability at the same time. It sounds procedural. It isn’t. The Fed’s asset holdings shape the quantity of reserves in the system, how smoothly repo markets fund themselves and whether the policy rate reaches money markets — and from there the broader economy — reliably. A chair who treats runoff as a toughness signal could easily collide with the plumbing of the system he is trying to steer.

The New York Fed’s speech on policy implementation in an ample-reserves regime makes the same case from the operations side. The central bank works best when reserves sit comfortably above the level where funding markets start to buckle. Policymakers do not learn that threshold from a press release. They learn it when repo rates spike, settlement turns noisy and banks start bidding for liquidity. September 2019 is the standing cautionary tale. Reserves looked ample right up until they weren’t. The market discovered the line before policymakers admitted where it was.

Researchers at the Kansas City Fed have mapped the balance sheet’s evolving role from a longer vantage point. Their work shows how the portfolio now shapes financial conditions through several channels at once — market functioning, bank balance-sheet capacity and the signal sent by asset purchases or runoff. That matters in 2026 because Warsh faces a harder task than unwinding an old crisis toolkit. He has to manage a framework that has been baked into everyday policy transmission at the same moment inflation risk has returned.

The higher-for-longer constraint

The market backdrop makes the transmission question harder to ignore. Traders were pricing a 42 per cent chance of a Fed hike by year-end and a 4.2 per cent implied probability of a move as soon as July, CNBC reported, citing CME FedWatch data. Those aren’t dominant odds, but they signal something concrete: investors are no longer treating the path ahead as one-way easing. In that setting, balance-sheet policy stops being a separate housekeeping exercise. Runoff, reserve scarcity and rate expectations can hit Treasury yields all at once.

That is the practical reason former officials are pressing Warsh to think about transmission before symbolism. Keep the policy rate restrictive while quantitative tightening grinds on and the combined effect could surface in places that register fast: money-market volatility, thinner Treasury-market depth, wider mortgage spreads and a choppier pass-through from the Fed’s target range to real-world borrowing costs. None of that guarantees a crisis. It does mean you cannot judge the balance sheet by size alone. A smaller portfolio that produces rougher financing conditions is not cleaner policy. It is poorer control.

Warsh’s immediate problem is sequencing and communication. CNBC’s report on his swearing-in cast him as the next steward of a central bank under both political pressure and market scepticism. Former governor Randall Kroszner, again speaking to Reuters, said the Fed should articulate balance-sheet decisions in advance — otherwise markets will read every adjustment as a disguised shift in the rate stance. That may be the best advice in the room. Investors can absorb a hard message. What they react badly to is an institution that looks like it is sending two different signals at once.

For markets, the cleanest takeaway is that the next Fed debate will probably centre on operating design, not the portfolio’s headline size. Analysts will track reserve balances, repo conditions, Treasury auction digestion and the language around runoff for clues about where the real constraint sits. If those indicators stay orderly, Warsh will have room to keep shrinking assets gradually. If they start to wobble while inflation stays uncomfortably firm, the chair may discover that balance-sheet orthodoxy is the easier slogan and the harder policy. The former officials pushing him on this are arguing for something specific: a Fed that keeps its grip on transmission first and treats the asset total as a consequence, not an objective.