Federal Reserve Governor Michael Barr on Thursday cautioned against efforts to shrink the U.S. central bank’s balance sheet by easing liquidity requirements for banks, arguing that such a move could weaken the resilience of the financial system and heighten risks during periods of market stress.
Speaking at an event hosted by the Money Marketeers of New York University, Barr said recent discussions around reducing the Federal Reserve’s “footprint” in financial markets by cutting the size of its balance sheet were misguided. Barr warned that several proposals aimed at achieving that goal could undermine bank resilience, disrupt money market functioning and ultimately threaten financial stability.
Barr said lowering liquidity requirements for banks to reduce the Fed’s asset holdings could increase the likelihood that financial institutions would need emergency support from the central bank during crises. He added that the banking turmoil witnessed in 2023 suggested regulators should consider strengthening liquidity requirements rather than weakening them.
The Fed governor also argued that the size of the central bank’s balance sheet should not be viewed as the primary measure of its influence in financial markets. Instead, he said, the key focus should remain on the effectiveness of monetary policy implementation.
Barr’s remarks come at a time when debate is intensifying over the future direction of the Federal Reserve under Kevin Warsh, widely viewed as the leading candidate to succeed current Fed Chair Jerome Powell. Warsh, a former Fed governor, has been critical of the central bank’s extensive use of asset purchases during the 2008 financial crisis and the COVID-19 pandemic.
Warsh believes the Fed’s large-scale bond-buying programs left the central bank’s balance sheet excessively large relative to financial markets and distorted market pricing. The Fed’s holdings surged to nearly $9 trillion by mid-2022 after aggressive purchases of Treasury and mortgage-backed securities during the pandemic. Subsequent balance sheet reduction efforts have trimmed more than $2 trillion from those holdings.
The Federal Reserve currently holds around $6.7 trillion in assets and has recently been purchasing Treasury bills in what officials describe as a technical operation aimed at maintaining adequate liquidity and aligning reserves with economic growth.
Reuters reported that Warsh has also argued that a smaller Fed balance sheet could allow policymakers greater room to cut interest rates. However, critics contend that the current monetary policy framework — which relies on ample reserves in the banking system — limits how much the Fed can reduce its holdings without impairing control over short-term interest rates.
Barr highlighted the risks associated with allowing banks to operate with lower liquidity buffers during a period of heightened economic uncertainty. Some academics and market observers have similarly warned that lower reserve levels could increase the probability of financial instability.
Following his speech, Barr said he had not yet decided how he would approach the Federal Reserve’s upcoming monetary policy meeting, where officials are weighing the implications of an energy-driven inflation shock whose duration remains uncertain.
