By Michael S. Derby

April 21 (Reuters) – Kevin Warsh would like to see the Federal Reserve slash its vast bond holdings, but has yet to flesh out just how he would do that if confirmed to be the next head of the U.S. central bank, a matter likely to come up in his confirmation hearing on Tuesday before the Senate Banking Committee.

Meanwhile, in the absence of specifics from Warsh, an effort is underway both in and outside the Fed to provide some intellectual heft for that goal.

The academic work largely agrees that if the central bank wants a smaller footprint in financial markets, the key is reducing financial institutions’ need to hold large amounts of cash. Academics and some Fed officials say regulatory changes allowing banks to hold less in the form of reserves are the primary path toward getting the balance sheet down, adding that changes in how the Fed uses its rate-control toolkit could also help.

Some modifications could in theory allow the Fed to pursue an easier stance of monetary policy than would otherwise be the case, although it remains unclear how that would play out.

But easing rules inducing financial institutions to hoard cash also could create other risks for the broader financial system.

“We have been encouraged by the evolution of the (Federal Open Market Committee) debate on the size of the balance sheet over the past couple of months” and there is “widespread agreement that there are regulatory opportunities to reduce that basic level of reserve demand,” analysts at Wrightson ICAP said in a note to clients last weekend.

REGULATION REVIEW

Fed Governor Stephen Miran in a research paper last month argued that the central bank’s $6.68 trillion in assets could be cut by as much as $2 trillion by loosening liquidity regulations, making adjustments to bank stress testing and working to bolster usage of existing Fed liquidity tools.

Dallas Fed President Lorie Logan, who was a key architect of the central bank’s monetary policy mechanics at the New York Fed, agreed early this month that rule changes around liquidity, among other options, could lower reserves and pave the way to a smaller Fed balance sheet.

Reserves, a proxy for market liquidity, loom large in the debate over the Fed’s balance sheet, as the central bank manages their levels to achieve its interest rate target. If reserves get tight, money market rates can start to rise and threaten the central bank’s control over that target. If there’s too much cash in the system, the Fed reduces its bond holdings to siphon funds out of the system.

The Fed is currently rebuilding market liquidity levels after finishing the last chapter of its balance-sheet drawdown, and it has maintained firm control over the federal funds target rate range, a critical concern for its officials.

Starting during the 2007-2009 global financial crisis, the Fed has periodically used large-scale purchases of Treasury bonds and mortgage-backed securities to stabilize financial markets and bolster its economic stimulus work. Those balance sheet expansions have been followed by passive drawdowns joined with the evolution of a complex toolkit to manage interest rates.

Few experts believe the Fed can return to the system of so-called “scarce” reserves used prior to the financial crisis when Warsh initially joined the Fed as a governor.

SOME MEAT ON THE BONE

The recent work could help Warsh, should he be confirmed by the Senate, find a path toward lower Fed holdings and interest rates.

Miran argued in his paper that a smaller Fed balance sheet is a form of restraint on the economy, so the central bank could cut interest rates as a counterbalance.

Noting that the central bank’s balance-sheet expansion appears to lower long-term rates and bolster the economy, New York Fed President John Williams told reporters late last month that “if you’re going to shrink the balance sheet, that will presumably reduce aggregate demand in the economy, get higher long-term interest rates, and therefore you would have a little bit lower short-term interest rate” in reaction.

“I think that’s logical,” but it’s also unclear how much of this would be measurable in real-world terms, Williams said.

Still, there’s no sense any changes will happen quickly even under Warsh’s leadership.

“My bet is some of these things are quite live, but will take time to implement,” said Ellen Meade, a former high-ranking Fed staff member who is now a research professor at Duke University. She says the recent proposals could mitigate the need for the Fed to buy bonds to ease market stress.

What’s more, the recent work could help preserve the current ample reserves regime, “but within a system where banks have lower demand day to day because they can get liquidity from the central bank on demand,” she said.

(Reporting by Michael S. Derby; Editing by Paul Simao)

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