By Nicole Goodkind

Kevin Warsh, the former Federal Reserve governor nominated by President Donald Trump to lead the central bank, has made shrinking the Fed's roughly $6.7 trillion balance sheet a central part of his vision for monetary policy.

In speeches and interviews, Warsh has argued that years of bond buying have left the Fed too deeply embedded in financial markets, distorted capital-markets prices, and pulled the central bank into a role it wasn't designed to assume. A smaller balance sheet, in his view and that of his supporters, would help restore discipline and reduce the central bank's footprint.

But shrinking the balance sheet may be difficult to achieve. Over the past decade, banks, money-market funds, and the Treasury itself have come to depend on the large pool of reserves the Fed created through its bond purchases. Previous attempts to drain those reserves triggered disruptions in short-term lending markets.

Many investors and economists say the financial system has adapted over more than a decade to a Fed that keeps a large cash cushion in the banking system and holds trillions of dollars in government bonds and housing-related securities. As a result, the Fed effectively sets a floor under short-term interest rates by paying banks interest on the reserves they park at the central bank, a system that works best when reserves are plentiful.

Banks and other institutions rely daily on that abundance of cash to settle payments, fund trades, and lend to each other overnight in the repo, or repurchase market. When reserves grow scarce, overnight borrowing costs can spike, as they did in September 2019.

Policymakers began to reduce the balance sheet in June 2022, eventually allowing up to $60 billion a month in maturing Treasury securities and $35 billion in mortgage-backed securities to roll off without reinvesting the proceeds. The Fed slowed the pace of reduction in mid-2024 and halted the process entirely in December 2025, after signs of growing stress in money markets suggested reserves were approaching the minimum level the banking system needs to function smoothly.

A debate has since ensued on Wall Street about whether the Fed can shrink its balance sheet further without disrupting markets.

"The Fed is unlikely to make much progress in reducing its balance sheet, " David Kelly, chief global strategist at J.P. Morgan Asset Management, wrote in a note this week, pointing to regulatory constraints on banks, which are required to hold large quantities of high-quality liquid assets, including reserves; persistent demand from money-market funds and the Treasury to park cash overnight at the Fed; and political support for mortgage finance.

In holding roughly $2 trillion in mortgage-backed securities, the Fed has been a major buyer of housing debt, helping to keep mortgage rates lower than they might otherwise be. Reducing those holdings would force private investors to absorb more housing debt, likely at higher yields.

The Fed's balance sheet currently stands at just below $6.7 trillion. That is down from a peak of roughly $8.9 trillion during the Covid-19 pandemic, but more than eight times its size before the 2008-09 financial crisis. Previous efforts to trim the balance sheet proved difficult to sustain.

In 2019, the Fed was forced to start buying bonds again after having let its holdings decline for about two years. The reason: a sudden spike in short-term borrowing costs in the repo market. This episode, and last year's volatility in funding markets, have raised questions about how much further the Fed can go.

Still, Warsh's views are reshaping how some investors think about the future path of policy. Assuming his nomination is confirmed by the Senate, he will succeed Fed Chair Jerome Powell in mid-May, when Powell's term ends.

Warsh has suggested that the Fed could pair a reduction in the balance sheet with cuts in interest rates. In other words, the Fed would offer less support to the bond market by holding fewer securities, but compensate by moving its benchmark federal-funds rate lower.

That combination would mark a shift from recent policy. Some investors say it could ultimately support markets, particularly housing by reducing the distortions that years of Fed intervention have embedded in the mortgage market, allowing prices to reflect supply and demand more naturally over time.

A smaller balance sheet, combined with a pro-growth agenda, could make mortgage-backed securities more attractive and help strengthen the housing market, said Charles Tan, chief investment officer of global fixed income at American Century Investments.

Others see more immediate risks.

Reducing the balance sheet effectively drains cash from the banking system, tightening the supply of money available for lending in ways that aren't always predictable. In a market that depends on abundant cash reserves, even modest reductions can ripple through funding markets.

"Warsh combines a dovish view on interest rates with a hawkish approach to the Fed's balance sheet," said Maxime Darmet, senior economist at Allianz Trade. "This could drain liquidity from a highly leveraged financial system."

Darmet said it could lead to increased friction in money markets, and potentially elevate currency and interest-rate volatility.

The Fed's balance sheet was about $800 billion before the financial crisis, when the central bank managed interest rates in a system where banks held limited reserves. Starting in 2008, the Fed launched a series of emergency bond-buying programs, first to stabilize markets during the financial crisis, and later to stimulate the economy when cutting short-term rates to near zero wasn't enough. A further, much larger round of purchases followed during the pandemic, pushing the balance sheet to its peak of nearly $9 trillion.

These repeated rounds of bond purchases flooded banks with reserves and gave the Fed much greater influence over longer-term borrowing costs. By buying trillions of dollars in Treasury bonds and mortgage-backed securities, the Fed removed a large share of long-term debt from the market. With less supply available for private investors to buy, prices rose and yields fell. The result was that the Fed effectively pulled down the longer-term rates that markets typically determine.

Reducing the Fed's presence in the Treasury market could lead to higher long-term interest rates, because the government would need to sell more bonds to other investors, who would demand higher returns. A reduction in Fed holdings of mortgage-market securities could widen the gap between short-term rates and the mortgage rates home buyers pay, raising borrowing costs even if the Fed cuts its benchmark rate.

Supporters argue, however, that over time, removing the Fed's outsize presence would allow markets to price risk more accurately, reducing the boom-and-bust cycles that such intervention can create and producing a healthier foundation for the housing market and the economy.

For now, many economists expect the Fed to move cautiously. Analysts at Allianz Trade say the central bank is likely to delay any further meaningful reduction in its balance sheet until later this year. That approach may help limit volatility.

Shrinking the Fed's balance sheet has ample support, including among some prominent economists and Treasury Secretary Scott Bessent, who has expressed similar concerns about the Fed's role in bond markets. But after more than a decade in which the central bank has operated as one of the largest players in financial markets, reducing that role without rattling the system may be a tall order.

Write to Nicole Goodkind at nicole.goodkind@barrons.com

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March 26, 2026 01:00 ET (05:00 GMT)

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