A recent study by the Brookings Institution in the United States provides a clear roadmap: the Federal Reserve can achieve balance sheet reduction through reforms to liquidity tools and eased bank regulations, while still maintaining firm control over short-term interest rates and avoiding a liquidity crisis in financial markets.
A new study by the Brookings Institution in the United States suggests that the Federal Reserve could reduce its balance sheet size from the current level of approximately $6.8 trillion to around $4.5 trillion by reforming liquidity management tools and reducing banks’ structural demand for reserves, while maintaining effective control over short-term interest rates.
This report, authored by Chris Hughes, a non-resident fellow at the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, argues that the Federal Reserve need not maintain a large stock of reserve balances indefinitely. By establishing new mechanisms capable of flexibly providing liquidity in response to market demand and simultaneously adjusting bank regulatory rules, the central bank could reduce its balance sheet without causing liquidity stress in the financial system.
Transition from "sufficient reserves" to "flexible reserves"
The core of the report is to shift the Federal Reserve’s current “Ample Reserves” system to an “Elastic Reserves” system.
Under the current framework, the Federal Reserve tends to maintain a large level of reserves in the banking system to control short-term funding costs through a set of interest rate tools. This system was gradually established after the 2008 global financial crisis, when the Fed lowered interest rates to near zero and made large-scale purchases of assets such as Treasury securities to stimulate the economy and stabilize financial markets.
During the COVID-19 pandemic, the Federal Reserve again engaged in large-scale bond purchases, expanding its balance sheet from under $1 trillion before the crisis to a peak of approximately $9 trillion in 2022. Since then, the central bank has begun reducing its holdings by allowing maturing assets to roll off passively, but the balance sheet remains at a high level.
Hughes proposed that effective monetary policy operation does not require maintaining such a large level of reserve balances at all times. The Federal Reserve could reduce the amount of reserves in the system from the current level of approximately $3 trillion to about $1 trillion, while swiftly supplementing liquidity through more flexible lending tools when needed.
If implemented, the plan would reduce the Federal Reserve’s balance sheet as a percentage of GDP to its lowest level since 2008. The report also estimates that interest payments on bank reserves could decline by approximately two-thirds, helping to reduce the costs associated with the large balance sheet.
Reform liquidity tools to avoid funding strain caused by balance sheet reduction.
To significantly reduce reserve levels without affecting interest rate control, the Federal Reserve needs to adjust its existing tools and establish new liquidity support mechanisms.
First, the report recommends reforming the Standing Repo Facility, a tool that provides short-term funding to eligible financial institutions. Hughes advocates eliminating its funding cap and setting its rate above the reserve interest rate, enabling it to serve as a more robust liquidity backstop during periods of market tightness.
Second, the Federal Reserve should introduce a new term liquidity facility that provides funding with a maturity of approximately four months through auctions, accepting a broader range of collateral. The discount window would continue to serve its emergency financing function, supporting financial institutions facing liquidity pressures.
In terms of asset allocation, the report recommends that the Federal Reserve further shift its holdings toward short-term Treasury bills and reduce its holdings of long-term Treasuries and mortgage-backed securities. Hughes also advocates that the Federal Reserve target the Secured Overnight Financing Rate (SOFR) rather than the federal funds rate as its operational target.
The common goal of these adjustments is to enable the Federal Reserve to meet financial institutions’ temporary funding needs through market-based financing tools without relying on a large stock of reserves. The report suggests that the Bank of England’s approach to liquidity provision, as well as certain financing tools previously used by the Federal Reserve, could serve as useful references for the new framework.
However, merely increasing liquidity tools is not sufficient to achieve long-term balance sheet reduction. Hughes emphasized that the Federal Reserve must also simultaneously reduce the structural demand for reserves by banks, including adjusting bank regulatory rules and changing how the U.S. Treasury manages its cash account at the Federal Reserve. If banks continue to require large amounts of reserves, the new tools alone will be unable to support a permanent contraction of the balance sheet.
Reforms are divided, with the key challenge being how to balance stability and scale.
Supporters of balance sheet reduction argue that the Federal Reserve’s long-term holding of large amounts of Treasury securities and mortgage-backed securities distorts market pricing and gives the central bank some influence over long-term borrowing costs. Reducing these holdings is expected to lower the Fed’s influence in the market and alleviate the financial pressure from interest payments on reserves.
However, the current system is not without its supporters. John Williams, President of the New York Fed, previously stated that the “ample reserves” system has proven effective in controlling interest rates and ensuring the smooth functioning of core financial markets. Some experts also believe that banks holding sufficient cash helps them withstand financial stress and sudden shocks.
Wash himself also acknowledged that the existing system has taken years to develop and cannot be changed overnight. Therefore, even if the Federal Reserve is determined to reduce its balance sheet, key aspects of the reform will include setting the appropriate level of reserves, ensuring that repurchase tools function effectively during periods of stress, and preventing money market interest rates from spiraling out of control.
Hughes hopes that the Fed’s balance sheet working group will ultimately produce a clear, actionable reform plan. Given that the reforms involve multiple interrelated policy tools and regulatory rules, he believes the leadership of the Fed Chair is essential; Congress can also advance necessary adjustments through legislation.
This study offers a more comprehensive approach than passive balance sheet reduction alone: reducing the Fed’s long-term asset holdings and bank system reserves on one hand, while preserving the ability to quickly provide liquidity when market funding gaps emerge. Whether this plan can be implemented depends on whether the Fed is willing to restructure its current operational framework and whether regulatory and fiscal management rules can be aligned accordingly.