The Federal Reserve's "slimming down" dilemma: Top economists sketch out a roadmap for Powell's balance sheet reduction, reform may take up to 5 years.

President of the Federal Reserve nominee Kevin Warsh has expressed his hope to significantly reduce the Federal Reserve's $6.6 trillion balance sheet; however, a top financial economist has stated that he may need more than one term to accomplish this task. Stanford Graduate School of Business professor and long-time advisor to the Federal Reserve, Darrell Duffie, pointed out in a new paper that if the Federal Reserve wants to substantially reduce its influence in the financial markets without causing severe stress, reforms are necessary, including a thorough overhaul of bank liquidity requirements and redesigning the payment system. Once Warsh is appointed by the U.S. Senate, with the support of his colleagues, he can immediately implement some reforms. Duffie stated that other reforms may take up to five years, which means the work will continue beyond Warsh's four-year term as chairman. "This is akin to overhauling the world's largest payment system," Duffie said in a Monday conference call with journalists discussing one of the several measures he proposed. "You can't just write a few lines of code, plug them back into the system, and expect it to function properly. It requires a lot of testing." In a paper published by the Brookings Institution on Wednesday, Duffie outlined four recommendations the Federal Reserve could take to reduce banks' need for cash reserves held in central bank accounts. Currently, banks have about $3 trillion in funds deposited with the Federal Reserve, in part to comply with liquidity regulations imposed on banks after the 2008 financial crisis. Federal Reserve officials have readily accepted this arrangement as it also provides a simpler way to control short-term interest rates. During the search for a new Federal Reserve chairman, President Trump has indicated that the ability to immediately lower interest rates would be a litmus test for his choice of nominee. Ultimately, Warsh, who emerged victorious, believes that reducing the Federal Reserve's balance sheet will pave the way for interest rate cuts. However, he did not elaborate on how this would be achieved. Federal Reserve Vice Chair of Supervision, Michelle Bowman, and Treasury Secretary, Scott Bennett, appointed by Trump, have also proposed reducing liquidity requirements to lower the demand for reserves. Nonetheless, investors and Federal Reserve observers are still speculating on how all of this will ultimately unfold. Duffie's paper provides a roadmap. Firstly, the New York Federal Reserve could rely more on temporary open market operations, which is a tool it has extensively used in the past. According to Duffie, this would be the simplest way to smooth out fluctuations in reserve demand, and could be implemented within a few weeks. Next, adjustments will be made to liquidity regulations and supervisory measures. Duffie stated that these adjustments may take several months to complete. Furthermore, this work will require clear communication with regulatory agencies to avoid banks being penalized for using tools like the Federal Reserve discount window. While financial markets have always encouraged the use of the discount window, it has historically carried a stigma. The Federal Reserve could also opt to pay lower interest rates on reserve balances exceeding specific targets or quotas. Duffie stated that these measures can be implemented quickly, but achieving widespread consensus on their design and communication may take several years. Lastly, the Federal Reserve could adopt liquidity-saving mechanisms in its payment system, similar to other central banks (such as the Reserve Bank of New Zealand). However, Duffie noted that this would require changes from not only the Federal Reserve but also commercial banks, and could take up to five years. "You can't do anything without reducing the demand for reserves," Duffie said regarding Warsh's desire to shrink the Federal Reserve's balance sheet. "You could start by implementing one or two recommendations, which may have some effect," referring to the four recommendations Warsh proposed. "If you want to have a significant impact, it will require considerable effort."