Fed Policy Unlikely to Change Quickly Under Kevin Warsh, Analysts Say

Analysts at Morgan Stanley do not expect a sudden change in how the Federal Reserve operates if Kevin Warsh becomes the next Fed chair.

According to a recent note cited by Investing.com, Warsh’s nomination has renewed debate around the Fed’s balance sheet, its role in markets, and how it communicates policy. Still, economists say meaningful change would take years, not months, due to built-in limits within the financial system.

Big Ideas, Slow Reality

Warsh has long argued that the Fed plays too large a role in financial markets. His concerns focus on three main areas: the size of the central bank’s asset holdings, blurred lines between monetary and fiscal policy, and a communication style that can strongly move markets.

Even so, Morgan Stanley economists do not believe a Warsh-led Fed would quickly adjust interest rate policy or overhaul its market approach.

“We think a rapid shift in the Fed’s footprint is unlikely,” said the analyst team led by Michael Gapen.

They added that while balance sheet strategy could change over time, the process is complicated and closely tied to how banks manage liquidity.

Reserve Levels Are the Main Limitation

One of the biggest obstacles to shrinking the Fed’s balance sheet further is reserve demand within the banking system.

The Fed has already reduced its balance sheet from about $9 trillion to $6.6 trillion, mostly by cutting back overnight reverse repurchase agreements. However, bank reserves themselves have stayed largely unchanged.

Further reductions would begin to drain reserves, shifting the system from an “ample” reserve environment to a “scarce” one. That shift could push short-term funding rates higher and create stress in money markets.

Because of this risk, analysts believe the Fed will move very carefully.

Regulations Keep Reserve Demand High

Since the 2008 financial crisis, banks have been required to hold higher liquidity buffers under rules such as the Liquidity Coverage Ratio and internal stress testing standards.

Those rules have increased banks’ demand for reserves, making it harder for the Fed to shrink its balance sheet without disrupting the system.

While regulatory changes could lower reserve demand, Morgan Stanley analysts say that would come with trade-offs.

Reducing liquidity buffers could weaken the system’s ability to handle future financial stress. As the economists put it, there is “no free lunch.”

Mortgage Bonds Will Take Years to Run Off

Another slow-moving area is the Fed’s holdings of mortgage-backed securities.

Because mortgage rates have stayed high since 2022, homeowners are refinancing less often. That has sharply slowed the natural runoff of agency MBS from the Fed’s balance sheet.

Morgan Stanley estimates it could take nearly ten years for the Fed to cut its MBS holdings in half through runoff alone, even if mortgage rates fall meaningfully.

Active sales are seen as unlikely. Selling MBS could widen spreads, reduce liquidity, hurt housing affordability, and lead to realized losses outcomes the Fed would prefer to avoid.

Treasury Coordination Could Help, Slowly

Some balance sheet adjustments could happen through coordination with the U.S. Treasury.

The Treasury’s General Account has grown to nearly $1 trillion since the financial crisis and the pandemic. Cutting that balance could allow the Fed to reduce securities holdings without draining reserves.

Analysts also note that changes to the maturity mix of Treasury holdings favoring shorter-term securities could support gradual balance sheet changes over time.

Higher Bar for Future QE

Looking ahead, Morgan Stanley economists believe the Fed has raised the threshold for using tools like quantitative easing.

Under current preferences, asset purchases would likely return only during a recession severe enough to push rates back toward zero. Even then, reserve-management purchases would probably be used more selectively than in the past.

Bottom Line

Even if Kevin Warsh brings a different philosophy to the Fed, analysts say structural limits, bank regulations, and market risks will keep change slow and measured. Any shift in the Fed’s footprint would likely unfold over many years, not in the early days of a new chair. For direct financing consultations or mortgage options for you visit 👉 Nadlan Capital Group.