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.

The system "has proven to be highly effective at delivering interest rate control and supporting the smooth functioning of core financial markets,” New York Fed leader John Williams said on Sept. 22 at a conference at his bank.

Critics of the Fed’s large holdings, Warsh among them, believe that large Fed holdings of Treasury and mortgage bonds distort financial markets and put the institution too much in the place of setting longer-term borrowing levels. That said, Warsh has noted that the current regime has taken years to build and can’t be changed overnight.

In his paper, Hughes noted “a large, fixed stock of reserves is not necessary to implement monetary policy effectively, and the Federal Reserve can reliably do so through a smaller structural stock backed by elastic lending capacity.”If the Fed puts less liquidity into the system, it should change the standing repo operations tool, which provides fast cash to eligible firms, to have no cap and a higher rate than the interest on reserves rate, while launching a “new” Term Liquidity Facility to auction off four-month funding against a broad range of collateral.

The Discount Window would also remain in the mix for emergency lending and Fed holdings should be moved to Treasury bills and away from longer-dated holdings, among other proposed changes. It should also set a target for the Secured Overnight Financing Rate and stop targeting the federal funds rate, the paper said.

Hughes writes this would echo how the Bank of England provides liquidity to markets while at the same time drawing on past liquidity facilities offered by the Fed.

“The development of new facilities must be paired with policy changes to reduce structural reserve demand” and this can be done in part by changing the rules around banking regulation as well as how the Treasury manages its large-sized cash account at the Fed, the researcher said.

“New liquidity facilities and policies to reduce reserve demand are necessary complements; neither effectively delivers a permanently smaller balance sheet without the other,” Hughes wrote.

Huges also wrote he hopes the Fed balance sheet task force should “deliver a concrete blueprint” for contracting Fed holdings and not just a list of options.

“Leadership from the Chair is critical, given the overlapping mandates and interlocking tools required to update the operating system,” Hughes added, while noting Congress could also legislate the change he thinks is needed.