Warsh's impact on the Fed balance sheet may be all bark and no bite

Overview

The report discusses how Kevin Warsh might adjust the Fed balance sheet if he were to become Fed Chair. BofA's core conclusion is that Warsh would focus on the size and composition of the balance sheet, but under a normal policy path it would be hard to materially shrink it; composition changes could accelerate, such as allowing MBS to roll off and shifting reinvestment toward short-dated U.S. Treasuries, but the impact on the U.S. Treasury market and financial conditions is expected to be limited.

Core views

First, once the Fed balance sheet has normalized, it is mainly determined by the liability side, and among currency, TGA, and reserves, the only item that can be marginally affected by policy is reserves. Second, Warsh is unlikely to adopt bank-unfriendly measures such as reserve caps or tiered interest on reserves, because these would weaken bank liquidity, risk-taking, and lending willingness. Third, the more likely path is to reduce reserve demand through regulatory easing such as prepledge discount window collateral and broader HQLA recognition; reserves could fall by roughly $200 billion to $500 billion, or about 10% of the total, but the process would be slow. Fourth, changes in asset composition, such as the natural runoff of MBS and the reinvestment shift toward short-dated USTs, are already priced in by the market or implemented through auction add-on mechanisms, so they are unlikely to create a significant market shock.

Analysis framework

The report analyzes the Fed balance sheet separately from the liability side and the asset side. On the liability side, it examines whether currency, TGA, reserves, and RRP can be compressed; on the asset side, it looks at MBS runoff, the shortening of the WAM of U.S. Treasury holdings, and whether the Treasury would offset the Fed's reinvestment changes. The report also uses a reserve supply-and-demand curve framework to explain how regulatory easing can first push down funding rates and then allow the Fed to gradually reduce reserve supply.

Methodology notes

• Monetary policy frameworkAbundant reserves and scarce reserves framework

  Abundant reserves mean that changes in reserves cause only limited money market rate volatility; scarce reserves mean that changes in reserves cause large money market rate volatility.

  The report believes Warsh is likely to support an abundant reserves regime because it is operationally simple, reduces money market volatility, and helps maintain looser financial conditions.

• Balance sheet analysisLiability-side constraint framework

  After normalization, a central bank balance sheet is determined by core liability demand.

  The report splits Fed liabilities into currency, TGA, and reserves, arguing that currency is essentially exogenous, TGA has limited room to adjust, and reserves are the variable Warsh is most likely to influence.

• Money market mechanismSRP=IOR blue-sky scenario

  Set the bank standing repo rate equal to IOR so that banks can obtain cash from the Fed at market-based prices using UST or Agency collateral.

  This mechanism could reduce banks' need to hold reserve buffers; if combined with reduced stigma from weekly regional reserve distribution disclosures, the effect could be stronger.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• U.S. Treasuries

  Core asset for Fed reinvestment and WAM adjustment

  Strengths

  Short-dated reinvestment could accelerate the decline in the WAM of Fed holdings, but the effect may occur through auction add-on mechanisms and may not change overall market supply and demand.

  Weaknesses

  If the Treasury unexpectedly adjusts issuance to offset Fed behavior, the market impact path would change.

  Comparison

  Compared with MBS, USTs are the main receiving asset for Fed asset composition adjustments.

  Risks

  Changes in Treasury issuance strategy, repricing of WAM changes by the market, liquidity shocks.

• MBS

  An asset class that is gradually rolling off the Fed's asset side

  Strengths

  The runoff path from natural maturities and prepayments is clear, and the market already expects it.

  Weaknesses

  Runoff is slow, and the report sees a low probability of direct MBS sales.

  Comparison

  Compared with USTs, MBS is more of a passive reduction item than a source of active policy shock.

  Risks

  If direct MBS sales or a policy-agency backstop arrangement emerges, market expectations could change.

• Bank reserves

  The most likely lever for Warsh to compress the Fed balance sheet

  Strengths

  Reserve demand has room to fall through liquidity-regulation easing, prepledge arrangements, and the SRP mechanism.

  Weaknesses

  The decline would be limited and slow; excessive compression would increase money market volatility.

  Comparison

  Compared with currency and TGA, reserves are more policy-operable.

  Risks

  Reserve levels that are too low could cause funding rate volatility, tighter bank liquidity, and an unexpected tightening in financial conditions.

• Money market funding rates

  The direct observable variable after reserve demand shifts left

  Strengths

  Can serve as an early signal that regulatory easing is reducing reserve demand.

  Weaknesses

  The conceptual chart does not provide precise values, and actual rate responses are affected by multiple factors.

  Comparison

  Compared with long-term rates, short-term funding rates more directly reflect reserve supply-demand changes.

  Risks

  Unusual widening of TGCR, repo rates, or spreads near IORB.

Key data

• Potential decline in reservesAbout $200 billion to $500 billionBofA estimates the decline in reserve demand that bank-friendly liquidity-regulation easing could produce, equal to roughly 10% of the total and likely to materialize slowly.
• Expected TGA levelAbout $900 billion at the end of Q2 2026 and about $950 billion at the end of Q3 2026The report says the U.S. Treasury has limited interest in materially lowering TGA; TGA repo investment may occur but its impact would be small, and TT&L is unlikely.
• MBS size and runoff paceAbout $2 trillion in MBS, with monthly runoff of about $10 billion to $20 billionThe Fed is expected to continue letting MBS mature and prepay off its balance sheet and to reinvest in T-bills; the report believes this has already been priced by the market.
• Fed WAM scenarioUnder the current trend, it would fall to about 85 months by 2028; under a 2Y-3Y reinvestment scenario, about 70 monthsThe chart shows that if coupon-bearing debt reinvestment is shifted into 2- to 3-year maturities, the Fed's UST WAM would decline faster, but the report still sees little market disruption.
• Report date2026-05-18Date on the report cover page.

Impact & implications

For investors, the implication is not to overstate Warsh's direct market impact on the Fed balance sheet. Even if Warsh pushes for balance sheet reduction or a shorter WAM for Fed Treasury holdings, the usual mechanism may not tighten financial conditions, and therefore does not constitute a sufficient reason for the Fed to cut rates. What is truly worth watching is the unconventional SRP=IOR bank proposal, as well as whether regulatory and disclosure changes significantly reduce banks' reserve buffer needs.

Risks

• If Warsh adopts bank-unfriendly policies such as reserve caps or tiered interest on reserves, bank liquidity and risk-taking could weaken.
• If reserves decline too quickly, money market rate volatility may rise and may force the Fed to provide liquidity again.
• If the U.S. Treasury unexpectedly offsets the WAM shortening caused by Fed reinvestment, the impact on UST supply-demand and the term structure could differ from the report's view.
• If foreign RRP attractiveness is lowered to push funds into repo or bills, it could undermine the dollar's reserve-currency status.
• The SRP=IOR blue-sky scenario involves institutional design and disclosure changes, and there is uncertainty around policy adoption and execution.

What to watch

• Whether Warsh formally pushes for a Fed balance sheet working group or related policy review.
• Whether the Fed continues to maintain an abundant reserves regime and how FOMC members comment on the reserve framework.
• Whether rules such as bank liquidity regulation, discount window prepledge, and HQLA recognition are eased.
• Whether the Fed adjusts the runoff of MBS and the tenor selection for UST reinvestment, especially whether coupon reinvestment shifts to 2- to 3-year maturities.
• Whether the TGA path, TGA repo investment, and TT&L-related policies change.
• Whether the SRP rate moves closer to IOR and whether the Fed adjusts regional reserve distribution disclosures to reduce stigma around using the tool.