Growing Scrutiny of the Fed's Monetary Policy Tools

In a notable development, a U.S. senator is attempting to curtail a key tool the Federal Reserve relies on to control interest rates. This, coupled with the ongoing competition for the position of Fed Chair, signals that the instruments policymakers use to influence the economy may face increased scrutiny in the future.

While there are no immediate changes to the Fed's monetary policy mechanism, the situation may not remain static – especially with former President Trump poised to nominate a successor to Jerome Powell, whose term ends next May. Trump has consistently criticized the Fed and called for lower interest rates.

Revisiting Interest on Reserves

The first sign of change came through the efforts of Republican Senator Ted Cruz, who last month pushed to end the Fed's practice of paying interest on reserves banks hold at the central bank. The influential "Project 2025" has also referenced this move. This project, pushing some of Trump's agenda since his potential return to power in January, aims to reshape many aspects of the federal government.

While Cruz's efforts appear to have limited impact currently, they could, if successful, upend how the Fed manages interest rates and have a significant impact on the central bank's massive bond holdings.

The Balance Sheet Under the Microscope

At the same time, how the Fed utilizes bond purchases and the balance sheet to stimulate or curb the economy is also under scrutiny. Since 2022, the Fed has been reducing its bond holdings. However, at least one potential successor to Powell hopes to shrink the balance sheet more aggressively, based on a new understanding of how the balance sheet affects the economy.

The Quandary of Interest Rate Tools

The Fed began paying interest on bank reserves during the 2008 global financial crisis. At that time, benchmark interest rates were near zero, and the financial system was awash in cash as a result of central bank bond purchases. The move allowed the Fed to gain the same degree of interest rate control as it had in a "time of bank reserve scarcity."

Over time, the Fed refined this system, formally establishing it in 2019. Officials do not intend to return to the system that existed before the crisis.

"The current mechanism has many advantages, and I don't think people fully realize that," said William Dudley, former President of the New York Fed, who was responsible for monetary policy implementation when the new system was established. "It makes monetary policy implementation very simple," allowing the Fed to manage reserve levels without actively intervening in the market.

However, this system has been criticized for being an unfair subsidy to the financial sector; it has also turned the Fed from consistently profitable to incurring losses. The profits the central bank used to remit to the Treasury to alleviate the federal deficit no longer exist until the central bank returns to profitability.

Cruz claims that his motivation to end this authority is ultimately to reduce the deficit. But critics believe that his goal of "effectively returning to the policy system that existed before the crisis" carries unintended consequences and misunderstandings.

Dudley points out that the losses are not inherent in the current interest rate control system, but are caused by the Fed's purchase of long-term bonds as a means of stimulus, leading to a mismatch between current income and interest expenses, and thus to losses.

Powell told a Senate committee in June, "If we want to return to a state of reserve scarcity, the road will be long, bumpy and volatile.""

Losing the authority to pay interest could force the Fed to aggressively reclaim the excess liquidity on which the current system relies, in order to prevent short-term interest rates from spiraling out of control. This could mean that the Fed would need to sell a large amount of the bonds it holds.

Ellen Meade, a former Fed official and professor of economics at Duke University, said, "I understand that some hope to return to the monetary policy framework that existed before the global financial crisis. But selling bonds in order to quickly reclaim liquidity would push up real interest rates, so any move to return to the system that existed before the crisis would bring macroeconomic pain.""

Disagreement Over the Size of the Balance Sheet

Even if the Fed's interest rate control tools are not touched, many questions will remain about how large its bond holdings should be maintained.

Since 2022, the Fed has reduced its bond holdings by more than $2 trillion, and market watchers estimate that the reduction will end when the balance sheet falls from the current $6.7 trillion to about $6.1 trillion. Christopher Waller, a potential successor to Powell, recently mentioned that holdings could be reduced to $5.9 trillion.

On the other hand, Kevin Warsh, a former Fed official allegedly on the short list for succession, hopes to make even larger cuts for unique reasons. In a recent television interview, Warsh suggested that the Fed's vision for the balance sheet should combine "interest rate cuts aimed at supporting the general public" and a "drastic reduction in bond holdings" - which he believes will curb speculation on Wall Street.

"We are skeptical of this policy proposal," wrote analysts at research firm Wrightson ICAP. But they pointed out that Warsh's view is a "vivid reminder that all US economic policies may be re-examined in the coming year."

It is not yet clear how much of this rhetoric directed against the Fed is mere posturing and how much is a real strategy for change.

Derek Tang, an analyst at forecasting firm LH Meyer, said, "Recent developments are largely related to 'Republicans sparing no effort in an ongoing campaign to pressure the Fed to ease policy overall.' The balance sheet is an important front because it is the area where Fed interest rate setting, portfolio decisions and the Trump administration's fiscal space intersect."