Brookings paper offers broad plan to shrink Fed balance sheet

Oct 21 (Reuters) - The Federal Reserve can substantially shrink its balance sheet if it overhauls its rate control toolkit to provide liquidity on demand, if those alterations are in made in conjunction with rule changes that allow banks to hold lower levels of cash on hand, says a new paper published by the Brookings ‌Institution.

The proposed roster of changes could allow the Fed to downsize overall holdings from their current $6.8 trillion level to around $4.5 trillion, with the proposed level of reserves in the financial ‌system ebbing from around the $3 trillion mark to around $1 trillion, wrote Chris Hughes, Nonresident Fellow at the think tank's Hutchins Center on Fiscal and Monetary Policy.

The paper argues now is the time to consider bold change given that new Fed Chairman Kevin ​Warsh wants a smaller Fed balance sheet and has named a task force to consider ways to make that happen.

"Opportunities to reset Fed operating systems do not come often," Hughes wrote, adding "this moment should not be wasted."

If done, "The Fed's footprint as a share of GDP would be smaller than at any point since 2008, and the interest paid to banks would fall by roughly two-thirds," Hughes wrote, alluding to Fed interest costs on its balance that have led the central bank into an unprecedented period of loss making.

The key to making this happen is moving away from the Fed's current system of so-called ample reserves, where it ‌aims to keep the financial system flush with large amounts of cash, ⁠with control of short-term rates delivered through a complicated toolkit and periodic waves of central bank bond buying.

The new system would be called "Elastic Reserves" and would be more responsive to market demand for cash, Hughes wrote.

The ample reserves system developed over the years following the global financial crisis, which kicked off nearly 20 ⁠years ago. The Fed's push then to near-zero interest rates drove it buy large amounts of bonds to provide economic stimulus and market stabilization.

The Fed again bought bonds in large numbers during the COVID-19 pandemic, and collectively those purchases drove overall central bank holdings from just under a trillion dollars to a peak of $9 trillion in 2022, before the central bank began passively reducing its bond holdings.

For many current Fed officials, while the levels of Fed ​holdings ​are large, ample reserves works in real world conditions. And a number of experts also reckon banks flush with ​cash are better prepared to deal with financial troubles when they arise.