Federal Reserve Faces Scrutiny Over Shrinking Balance Sheet Amid Powell Era Review

Federal Reserve Balance Sheet Shrinking May Not Be the Answer, Economists Warn

Two prominent economists have cautioned against significantly shrinking the Federal Reserve's balance sheet, warning that such a move could have substantial downsides with little upside. The warning comes as the Fed's new chairman, Kevin Warsh, has long called for a smaller Fed footprint in the financial system.

According to a report published by the Brookings Institution, economists Christina Romer and David Romer of the University of California, Berkeley, argue that while some reduction in the balance sheet may be justified, a significant shrinkage would be ill-advised. The report, titled "An Early Retrospective on Monetary Policy in the Powell Era," assesses the lessons from former Chair Jerome Powell's two terms running the Fed.

The Romers' caution is based on a lookback at the Fed's experience during the global financial crisis and the Covid pandemic. During this time, the Fed's balance sheet surged to $6.7 trillion, featuring almost $4.5 trillion of Treasuries and nearly $2 trillion of mortgage securities. This increase in the Fed's "imprimatur" on the economy has allowed for lower interest rates and stricter lines between monetary and fiscal policy, according to Warsh.

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However, the Romers argue that a smaller balance sheet would not be beneficial. They point to the experience of 2019, when the Fed called off a previous effort to run down the balance sheet, after it ended up roiling money markets. Last year, the Fed ended its second quantitative tightening initiative to ensure an ample amount of reserves in the financial system and avoid a repeat of the 2019 experience.

Comparison of the Fed's Balance Sheet Under Different Chairs

The Romers also caution against the Fed's large holdings of mortgage-backed securities, which they argue favor one particular sector of credit. They suggest increasing the pace at which the Fed shrinks its MBS holdings, which would take over a decade at the current rate.

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In addition to their warning on the balance sheet, the Romers recommend that the Fed move quickly when conditions change and that inflation hurts the economy even if inflation expectations remain anchored. They also caution against the use of forward guidance, arguing that it should be used sparingly and with a wide range of possible paths for the economy in mind.

The report credits former Fed Chairs Ben Bernanke and Janet Yellen, among others, for comments and suggestions on their assessment.