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Warsh wants to shrink the Fed balance sheet: that’s a dangerous idea.
The new Fed Chair Warsh is known for his strong ideas regarding the Fed balance sheet.
He believes the Fed is mostly a backstop for the US banking system, but it needs to get out when job is done. And that’s fair.
To do that, he wants to shrink the Fed balance sheet.
But that could cause trouble in the US repo market.
The chart below shows how bank reserves as % of total US nominal GDP have been shrinking and approaching the potentially dangerous 8-9% level – last time it breached that, we had a repo blowup in 2019.
This is because bank reserves are very unevenly distributed across US banks, and once they start becoming scarce the odds of interbank liquidity drying up for smaller banks increase.
Shrinking the balance sheet further here would put the stability of the repo market at risk, and by the way in December 2025 the Fed resumed purchases of T-Bills with the very intent to avoid such risks.
Do you think Warsh can convince his colleagues to reduce the Fed balance sheet? And will the repo market be able to absorb such a shock?
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