Fed's policy toolkit may be headed for fundamental changes

Reuters

29-07-2025

July 29 (Reuters) - A U.S. senator's recent push to strip the Federal Reserve of a key aspect of how it controls interest rates and the battle over who will succeed Fed Chair Jerome Powell point to a future where some of the tools policymakers use to influence the economy come under greater scrutiny.
There's no sense of imminent changes in the Fed's monetary policy mechanics. But that may not always be the case, especially as President Donald Trump, a persistent critic of the central bank who wants it to reduce interest rates, prepares to name a successor for Powell, whose term expires next May.
The first sign of shifting ground came from Republican Senator Ted Cruz, who last month pushed to end interest payments paid by the Fed on bank reserves parked at the central bank. Ending this practice was also cited, among other back-to-basics proposals, in the influential Project 2025 effort that has helped drive some of Trump's agenda since he returned to power in January.
Cruz's effort appears to have gained little traction, but success would upend how the Fed manages interest rates and have major implications for the central bank's large bond holdings.
Meanwhile, how the Fed uses bond purchases and its balance sheet to stimulate or restrain the economy is also getting attention. It has been shedding bonds since 2022, but at least one possible Powell successor wants an even more aggressive drawdown motivated by a novel understanding of how the balance sheet affects the economy.
The Fed began paying interest on bank reserves during the global financial crisis in 2008. With its benchmark interest rate near zero and the financial system flush with cash from the central bank's bond purchases, this move granted the same control over rates the Fed had when bank reserves were much less abundant.
Over time the Fed built out this system and formalized, opens new tab it in 2019. Officials have shown no desire to go back to the pre-crisis system.
"The current regime has a number of positive attributes that people I don't think fully appreciate," said William Dudley, a former head of the New York Fed who also managed the implementation of monetary policy when the new system was created. "It makes monetary policy execution really easy" and saves the Fed from active intervention in markets to manage reserve levels.
The system, however, has been dogged by criticism that it is an unfair financial sector subsidy. It has also pushed the Fed from a consistent profit maker to a money loser, and the profits it once handed to the Treasury to defray federal deficits are gone until the central bank can clear the red ink.
Cruz argued that his push to end the power was ultimately about lowering deficits. But critics contend his goal of a de facto return to the pre-crisis policy system was full of unintended consequences and misunderstandings.
Dudley said losses are not inherent to the current rate-control system but arise from the Fed having bought longer-dated bonds as a form of stimulus, creating the current mismatch between income and interest expenses that's led to losses.
Powell told a U.S. Senate committee in June that "if you were to want to go back to scarce reserves, it would be a long and bumpy and volatile road."
Losing interest rate-paying power could force the Fed to aggressively retire the excess liquidity that its current toolkit relies upon to prevent short-term rates from spiraling out of control. And that would likely mean the Fed would sell a substantial portion of the bonds it now owns.
"I understand there is a desire on the part of some to go back to the pre-(global financial crisis) framework for operating monetary policy," said Ellen Meade, a former top Fed staffer who is now an economics professor at Duke University. But the selling of bonds needed to draw down liquidity rapidly would push up real-world interest rates, "so any return to the pre-GFC system will involve macroeconomic pain."
Even without toying with the Fed's rate-control tools, questions abound regarding how big its bond holdings should be.
Since 2022 it has shed more than $2 trillion of bonds, and market participants estimate the reductions will end when the balance sheet drops to about $6.1 trillion from the current $6.7 trillion. Fed Governor Christopher Waller, who has been mentioned as a possible successor to Powell, recently said it's possible that holdings could drop to $5.9 trillion.
Kevin Warsh, a former Fed governor who is also said to be on the short list to replace Powell, wants to go much further, and for unique reasons. In recent television interviews, he's laid out a Fed balance sheet vision that would mix rate cuts aimed at bolstering Main Street with aggressive bond holding cuts, which he believes will tamp down Wall Street speculation.
"We're skeptical of that policy prescription," analysts at research firm Wrightson ICAP wrote. They noted, however, that Warsh's view "is a vivid reminder that everything in U.S. economic policy will be up for grabs over the coming year."
How much is bluster versus real strategy for change at the Fed is unclear.
When it comes to recent developments, a lot is tied to "Republicans leaving no stone unturned in their sort of ongoing campaign of pressuring the Fed for easier policy in general," said Derek Tang, an analyst with forecasting firm LH Meyer. "The balance sheet is a very big front for that, because it's sort of where the Fed's rate-setting and portfolio decisions intersect with the amount of fiscal space that the Trump administration has."