Trump nominates Kevin Warsh as the next Federal Reserve Chairman, raising market concerns about a potential adjustment in the relationship between the Federal Reserve and the Treasury.
Warsh has long criticized the Federal Reserve's balance sheet size, advocating for a significant reduction of the current $6.6 trillion bond holdings, and proposed a new agreement similar to the 1951 &#34;Federal Reserve-Treasury Agreement&#34; to redefine the policy boundaries between the central bank and the Treasury.
Treasury Secretary Scott Bessenet holds a similar position. Hedge fund investor Stanley Druckenmiller expressed his excitement about the upcoming collaboration between the two in an interview with the Financial Times last week, stating that if an agreement could be reached, &#34;it would be an ideal situation.&#34; Druckenmiller was previously an employer of both Bessenet and Warsh.
However, analysts point out that a significant reduction of the Federal Reserve's balance sheet faces multiple real-world challenges. Historical experience shows that any previous attempts by the Federal Reserve to shrink its balance sheet have triggered tensions in the money markets. In 2013, merely hinting at a gradual reduction in bond purchases led to severe global market volatility known as the &#34;taper tantrum.&#34; Additionally, aggressive balance sheet reduction could directly push up long-term interest rates, which Bessenet has previously identified as a core financial observation indicator.
Investors and Federal Reserve watchers are closely monitoring Bessenet's statements during congressional hearings on Wednesday and Thursday local time, hoping to capture clues about the future direction of policy collaboration.
<h2>Historical Lessons from the 1951 Agreement</h2>
After World War II, the Federal Reserve and the Treasury engaged in fierce battles over the independence of monetary policy. At that time, the Federal Reserve was concerned that excessive monetary stimulus was exacerbating inflation and wanted to exit the policy of suppressing Treasury yields for wartime financing, but the Truman administration insisted on maintaining low interest rates to control federal borrowing costs.
In 1951, the two parties ultimately reached the &#34;Treasury-Federal Reserve Agreement&#34;: the Federal Reserve ceased large-scale bond purchases to artificially suppress yields and gained the authority to independently use policy tools to address inflation. This agreement is regarded as the cornerstone of modern Federal Reserve monetary policy independence.
Warsh pointed out that the Federal Reserve's resumption and continuation of large-scale Treasury bond purchases during the 2008 global financial crisis and the COVID-19 pandemic have effectively deviated from the spirit of the 1951 agreement. He believes that by absorbing massive government debt, the central bank has fueled the ongoing expansion of fiscal spending, leading to a rise in U.S. debt to &#34;dangerous levels,&#34; which means the Federal Reserve has crossed the line and indirectly intervened in fiscal policy.
<h2>Possible Outline of a New Agreement</h2>
Neither Warsh nor Bessenet has provided detailed explanations of the so-called &#34;new agreement.&#34; Bessenet has explicitly stated that he only supports the Federal Reserve purchasing Treasury bonds under &#34;real emergencies and in coordination with other government departments.&#34; A simple new agreement might merely formalize this principle, similar to how Congress modified the Federal Reserve's emergency lending authority after the 2008 financial crisis, requiring any new liquidity tools aimed at non-bank borrowers to receive Treasury Secretary approval.
However, Warsh's proposals are clearly more radical. He calls for the Federal Reserve's balance sheet to return to its size before the 2008 financial crisis, effectively demanding that the central bank significantly shrink its assets that have expanded due to years of quantitative easing
<h2>Real Obstacles Facing Balance Sheet Reduction</h2>
According to an analysis by Reuters, significant structural constraints will face the substantial reduction of the Federal Reserve's bond holdings. Financial realities strongly indicate that this process may be slow and difficult, and may even be hard to fully achieve.
The current asset structure of the Federal Reserve and its interest rate management mechanism in a liquidity-rich environment aim to balance market stability with monetary policy goals, and its contraction space is actually limited. If the Federal Reserve Chairman attempts to lower short-term borrowing costs, actively reducing bond holdings may instead tighten financial conditions, contradicting policy objectives.
Joe Abate, an interest rate strategist at SMBC Capital Markets, pointed out that Walsh &#34;may wish to shrink the balance sheet size and reduce the Federal Reserve's presence in financial markets,&#34; but &#34;actual balance sheet reduction is not feasible... the banking system needs the current level of reserves.&#34; When bank reserves fall below about $3 trillion, money market interest rates often experience significant volatility, which may weaken the Federal Reserve's ability to control interest rate targets, constituting a substantial boundary for balance sheet size reduction.
Moreover, any major policy adjustments require the support of a majority of decision-makers within the Federal Reserve. Current officials generally agree to use the balance sheet as a normal policy tool and may be cautious about attempts to redesign that toolbox.
<h2>Possible Path for Gradual Adjustment</h2>
Analysts point out that if the regulatory burden on bank liquidity management is reduced and the attractiveness of central bank liquidity mechanisms such as the discount window and standing repo facility is enhanced, it may gradually alleviate banks' demand for high reserves, thereby creating space for the Federal Reserve to long-term reduce the size of its balance sheet.
David Beckworth, a senior researcher at the Mercatus Center at George Mason University, stated that in addition to the above measures, Walsh could also reassess the use of the balance sheet through the Federal Reserve's existing policy framework evaluation mechanisms. Furthermore, coordination between the Federal Reserve and the Treasury could be achieved through operations such as bond swaps. He commented:
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“The Federal Reserve is like a large ship that turns slowly, which may be a good thing, as hasty adjustments could shock the financial system.”
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Evercore ISI analysis believes that any action by Walsh regarding the balance sheet issue will be gradual and cautious, being wary of the risks of aggressive adjustments. The agency stated:
<blockquote>
“We believe he will be more pragmatic than the market expects, committing to avoid sudden shifts in the Federal Reserve's balance sheet policy and reaching an agreement with the Treasury to establish a framework for closer policy collaboration.”
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Analysts added:
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“The market may interpret this as granting Treasury Secretary Yellen a 'soft veto' over any balance sheet reduction plans, to which Walsh may be open.”
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Trump nominated Kevin Warsh as the Chairman of the Federal Reserve, whose core proposition is to push for a significant reduction of the Federal Reserve's massive $6.6 trillion balance sheet and seek a new agreement with the Treasury Department to clarify the boundaries of central bank independence and prevent fiscal monetization. Treasury Secretary Basant holds a similar position. However, this radical plan faces significant real-world resistance, including market "panic" triggered by previous rounds of balance sheet reduction in history, the potential for rising long-term interest rates, and the current banking system's reliance on high reserves. The market expects Warsh to adopt an extremely cautious and gradual strategy and establish a close collaborative framework with the Treasury Department

- Kevin Walsh's nomination as the next Fed Chair has heightened market interest in the potential shift of the Fed-Treasury relationship.  
- Walsh criticizes the Fed's oversized balance sheet and advocates for a significant reduction in its $6.6 trillion bond holdings, aiming to establish a new agreement akin to the 1951 Fed-Treasury accord.  
- Analysts suggest substantial balance sheet reduction faces serious challenges, warning that past attempts triggered market tensions and that any meaningful policy changes will require consensus among Fed officials.

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The Federal Reserve and the Treasury welcome a "new contract"? Waller advocates for balance sheet reduction, and the reality of liquidity may become the biggest stumbling block