Federal Reserve and Treasury Department usher in a "new contract"? Walsh advocates balance sheet reduction, but liquidity realities may become the biggest stumbling block.

Trump's nomination of Kevin Warsh as the next Federal Reserve Chair has sparked concerns in the market about potential adjustments in the relationship between the Fed and the Treasury. Warsh has long criticized the oversized Federal Reserve balance sheet, advocating for a substantial reduction of the current $6.6 trillion in bond holdings. He proposes reaching a new agreement with the Treasury, similar to the 1951 "Fed-Treasury Accord," to redefine the boundaries between central bank and fiscal policy. Treasury Secretary Scott Besant holds similar views. Last week, hedge fund investor Stanley Druckenmiller told the Financial Times that he was encouraged by their forthcoming collaboration, saying an agreement between the two would be "the ideal outcome." Druckenmiller previously employed both Besant and Warsh. However, analysts note that **a significant reduction of the Fed's balance sheet faces multiple practical challenges. Historical experience suggests that any previous attempt at balance sheet reduction by the Fed has triggered tensions in the money market.** In 2013, merely signaling a gradual tapering of asset purchases caused severe global market fluctuations, known as the "taper tantrum." Moreover, aggressive balance sheet reduction could directly drive up long-term interest rates, which Besant has previously cited as a core financial gauge. Investors and Fed watchers are closely monitoring Besant’s statements at Congressional hearings on Wednesday and Thursday (local time) for clues on future policy coordination. ## Historical Lessons of the 1951 Accord After WWII, the Federal Reserve and the Treasury engaged in fierce debates over monetary policy independence. At that time, the Fed worried that excessive monetary stimulus was adding to inflation, and wanted to end its wartime policy of suppressing government bond yields, but the Truman administration insisted on keeping rates low to manage the federal borrowing cost. In 1951, the two parties ultimately reached the "Treasury-Fed Accord": the Fed stopped artificially suppressing yields through large-scale bond purchases and gained the authority to independently use policy tools to fight inflation. This agreement is considered the cornerstone of the modern Fed's monetary policy independence. Warsh argues that the Fed’s large-scale bond purchases during the 2008 global financial crisis and the COVID pandemic essentially violate the spirit of the 1951 Accord. He believes, **by absorbing massive government debt, the central bank is fueling a continual expansion of fiscal spending, pushing U.S. debt to "dangerous levels"—meaning the Fed has crossed the line and effectively intruded into fiscal policy.** ## Possible Outline of a New Agreement Neither Warsh nor Besant has elaborated on the specific framework of a "new agreement." **Besant has clearly stated that he only supports the Fed purchasing government bonds "in genuine emergencies and with coordination from other government agencies."** A simple new accord might merely formalize this principle, similar to how Congress amended the Fed's emergency lending authority after the 2008 financial crisis—requiring Treasury Secretary approval for any new liquidity tools aimed at non-bank borrowers. Yet Warsh’s approach is evidently more far-reaching. He calls for shrinking the Fed’s balance sheet back to its pre-2008 levels, essentially demanding the central bank drastically reduce its asset holdings that have ballooned after years of quantitative easing. ## Practical Obstacles to Balance Sheet Reduction According to Reuters analysis, **a major reduction in the Fed’s bond holdings faces remarkable structural constraints.** Financial realities strongly suggest this process could be slow, difficult, and perhaps never fully achieved. The current structure of the Fed’s assets and its liquidity-focused interest rate management mechanisms are designed to balance market stability and policy goals, but actual room for shrinkage is limited. If the Fed Chair tries to lower short-term borrowing costs, slashing bond holdings would, paradoxically, tighten financial conditions and conflict with policy objectives. Joe Abate, rate strategist at SMBC Capital Markets, notes: **“Warsh may wish to shrink the balance sheet and reduce the Fed’s footprint in financial markets, but actual balance sheet reduction isn’t feasible…The banking system needs the current level of reserves.”** When bank reserves drop below about $3 trillion, money market rates often swing sharply, possibly undermining the Fed’s ability to steer rate targets. This reality sets a practical boundary for the scale of balance sheet reduction. Additionally, any major policy overhaul requires support from most Fed decision-makers. Current officials generally agree on employing the balance sheet as a standard policy instrument, and may be cautious about any attempt to fundamentally redesign this toolkit. ## Pathways for Gradual Adjustment Analysts point out that lowering the regulatory burden on banks’ liquidity management, and enhancing the appeal of central bank liquidity mechanisms such as the discount window and Standing Repo Facility, could gradually ease banks’ need for high reserves, thus creating room for long-term Fed balance sheet reduction. David Beckworth, senior fellow at the Mercatus Center at George Mason University, adds that besides these measures, Warsh could also use the Fed’s existing policy framework review mechanisms to reassess balance sheet practices. Furthermore, coordination between the Fed and Treasury might take forms like bond swaps. He comments: > "The Fed is like a large ship that turns slowly, and that may be a good thing because abrupt adjustments could shock the financial system." Evercore ISI’s analysis concludes that **any moves by Warsh on the balance sheet would be gradual and cautious, with an eye toward the risks of aggressive shifts.** The firm states: > "We expect he would be more pragmatic than expected, pledging to avoid sudden changes in balance sheet policy, and reaching an accord with the Treasury to establish a framework for closer coordination." Analysts further add: > "The market may interpret this as granting Treasury Secretary Besant a 'soft veto' over any balance sheet reduction plans, and Warsh might be open to this approach." Risk Warning and Disclaimer Markets have risks and investment should be undertaken with caution. This article does not constitute personal investment advice, nor does it consider any individual user’s specific investment goals, financial situation, or needs. 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