The Fed's "institutional reform" is coming? Powell may reshape a $6.8 trillion balance sheet, market worries about the end of the era of "Fed put"

With Kevin Warsh officially taking over as the Chairman of the Federal Reserve on Friday, Wall Street is engaged in fierce discussions about the "institutional reform" promised by the new leader. The focus of the market is not only limited to interest rate policies, personnel adjustments, or communication methods, but is also centered on a key issue that could potentially impact the American financial system over the next decade: whether the Federal Reserve will completely reshape its massive balance sheet. Several former Federal Reserve officials, economists, and recent research reports suggest that Warsh may push the Federal Reserve to reduce its daily interventions in the financial markets and redefine the rules for using the balance sheet during crises. In simple terms, the core of the current debate is whether the Federal Reserve should continue to use the balance sheet as a routine tool to influence financial conditions and support markets, as it has done for the past decade, or only use this tool in times of market malfunction or severe economic crises. From $800 billion to $9 trillion, the Federal Reserve's balance sheet "massive expansion" Before the global financial crisis erupted in 2008, the size of the Federal Reserve's balance sheet was only about $800 billion. However, in order to stabilize the financial system, the Federal Reserve subsequently implemented quantitative easing (QE) by purchasing large amounts of US Treasury bonds and mortgage-backed securities, leading to the balance sheet expanding to about $9 trillion at one point. Currently, the Federal Reserve's assets amount to $6.8 trillion, equivalent to about 23% of the US GDP, and about 7 times larger than the pre-crisis level. Over the past decade, the Federal Reserve's balance sheet has not only become an important tool for stabilizing the markets, but is also considered by some critics as one of the key factors driving the long bull market in stocks. Warsh has been critical of this system for a long time. Last year, he described the current balance sheet as "bloated" and believed that even with a reduction, the Federal Reserve could still cut interest rates. Warsh may push for a return to the "scarce reserve" system Currently, the Federal Reserve operates under the so-called "ample reserve" system. In simple terms, the Federal Reserve injects liquidity into the banking system by purchasing assets, and banks hold a large amount of reserves. Warsh has suggested that the Federal Reserve may return to the "scarce reserve" framework that existed before the financial crisis, and only inject liquidity into the market when necessary. There are speculations in the market that the Federal Reserve might change its core monetary policy transmission mechanism in the future. Steve Blitz, the Chief US Economist at TS Lombard, proposed that the Federal Reserve may rely more on the repurchase market as the core policy rate tool, rather than the current federal funds rate system. Blitz even suggested, "Repo rate will become the new policy rate." This theoretical change could allow Warsh to meet President Trump's demand for rate cuts while maintaining a tighter financial environment to address ongoing inflation pressures. Significant internal disagreements within the Federal Reserve Not all officials support significant reductions in the balance sheet. Vice Chairman Bar, who is responsible for regulatory affairs at the Federal Reserve, recently publicly opposed the direction of potential reforms. Bar stated that reducing the balance sheet is not the right goal in itself. He warned that some reform proposals could weaken the resilience of the banking system, disrupt the operation of the money market, and even threaten financial stability. Bar believes that focusing solely on the size of the balance sheet is too narrow-minded, and that what is more important is the maturity, structure and the reserve system itself. He also warned that lowering bank reserve requirements could exacerbate market volatility and compel the Federal Reserve to intervene more in the future. At the same time, several officials advocate for a "gradual reform" approach. Logan, who previously managed the trading desk at the New York Fed and currently serves as the President of the Dallas Fed, stated that any balance sheet reform must be carried out "slowly and cautiously." Mester, the former President of the Cleveland Fed, pointed out that the Federal Reserve has never truly established a clear framework for when to start QE and when to use it only for market repair. Market concerns over the end of the "Fed put" era Analysts point out that if Warsh does indeed lead the Federal Reserve to reduce market interventions, the long-standing expectation on Wall Street for the "Fed put" may be weakened. Lou Crandall, the Chief Economist at Wrightson ICAP, suggests that the Federal Reserve is likely to openly discuss the establishment of a more explicit framework for market interventions to avoid the assumption that central banks will "endlessly support the market." He believes that this will help markets form more rational expectations. However, several former officials emphasize that immediate drastic reforms should not be expected after Warsh takes office. Because the Federal Reserve's Federal Open Market Committee (FOMC) is fundamentally a consensus-based institution, significant policy shifts usually require long-term internal discussions. Mester stated that even after going through multiple chairpersons, the Federal Reserve's decision-making remains highly independent. She said, "Politics never enter the FOMC meeting room."