A Brookings paper proposes cutting the Fed’s balance sheet to $4.5 trillion with an elastic reserves system

The Federal Reserve could substantially shrink its balance sheet if it overhauled its toolkit for controlling interest rates to provide liquidity on demand, according to a paper published by the Brookings Institution¹.

The paper, by Chris Hughes, proposes replacing the Fed’s ample reserves system with what he calls “Elastic Reserves”, cutting the balance sheet from $6.8 trillion to $4.5 trillion². That is a reduction of about $2.3 trillion⁵.

The new system would be more responsive to market demand for cash, Hughes wrote⁷. The plan combines a redesign of how the Fed supplies liquidity with changes to bank regulatory rules⁶.

Why it matters to investors

The timing is deliberate. The paper argues that now is the moment to consider bold change, because Fed Chair Kevin Warsh wants a smaller balance sheet and has named a task force to consider how to achieve one^3,4.

A system that supplies cash only when the market demands it would, on the paper’s argument, let the Fed operate with a far smaller balance sheet than the ample reserves regime requires^1,7. The paper also addresses the legacy of the central bank’s bond buying⁷.

Not everyone at the Fed agrees with the premise. New York Fed President John Williams said in September that the ample reserves framework has been highly effective at controlling interest rates⁵.

The Fed’s Barr has said it would be wrong to lower liquidity rules in order to shrink the Fed’s holdings⁸. That objection goes to the regulatory half of the plan, since the paper’s route to a smaller balance sheet depends partly on adjusting bank rules⁶.

What to watch

The paper lands in a debate that Warsh has already opened. The work of the task force he named will show whether the Fed leadership leans toward a redesign of this kind^3,4.

The split between Williams’s defence of ample reserves and the paper’s call for an elastic system marks the main fault line in that debate^2,5.

For banks and money markets, the practical stakes are how much liquidity the Fed would stand ready to supply, on what terms, and how far bank rules would change to make a balance sheet of $4.5 trillion workable^2,6.