Written by Gunther Schnabl and Tom Bugdalle*

1. A Monetary Policy Turning Point in the United States?

For many years, the U.S. Federal Reserve, like the European Central Bank (ECB), conducted monetary policy through adjustments to key interest rates when bank liquidity was scarce. During the global financial crisis, however, this conventional monetary policy framework was replaced by unconventional monetary policy.

After policy rates had been cut to near zero, asset purchases—and thus changes in the size of the Fed’s balance sheet—became the primary monetary policy instrument. This unconventional policy influenced the economy and financial markets through changes in interest rates at the long end of the yield curve.

As a result of these asset purchases, the Fed’s balance sheet expanded dramatically. Despite the so-called quantitative tightening that began in 2022, the Fed’s balance sheet still amounts to USD 6.7 trillion (compared with EUR 6.2 trillion for the Eurosystem), significantly above its level before the turn of the millennium.

Current U.S. Treasury Secretary Scott Bessent has argued that through the massive expansion of its balance sheet, the Fed extended its authority beyond its statutory dual mandate of price stability and full employment.

According to Bessent, the Fed’s theoretical models were flawed, causing it to underestimate inflation risks and overestimate the growth effects of its policies. The Fed, he argues, redistributed wealth from the poor to the rich. Through excessive purchases of government bonds, it blurred the line between monetary and fiscal policy. In doing so, it not only facilitated unsound government fiscal policies but also gradually surrendered its independence.

Among the five candidates considered for the position, Kevin Warsh—widely regarded as Bessent’s preferred choice—ultimately won the race to become the new Fed Chair. Warsh served on the Federal Reserve Board of Governors under Ben Bernanke from 2006 to 2011 and sharply criticized the Fed’s programs aimed at stimulating growth and employment.

He resigned well before the end of his term. During the race for the Fed chairmanship, Warsh argued on the one hand that the Fed could lower interest rates if artificial-intelligence-driven productivity gains materialize, thereby aligning himself with President Donald Trump’s calls for rate cuts. On the other hand, during his Senate Banking Committee confirmation hearings, Warsh advocated a targeted reduction of the Fed’s balance sheet.

What direction can be expected for U.S. monetary policy under President Warsh? Will the world’s most important central bank gain or lose independence?

2. Core Elements of the Criticism by Warsh and Bessent

The size of the Federal Reserve’s balance sheet has grown substantially since the outbreak of the U.S. mortgage crisis through four rounds of quantitative easing. According to Bessent, the continuation of measures originally designed to stabilize financial markets during the global financial crisis systematically distorted capital markets. Massive bond purchases artificially compressed risk premiums and forced investors into riskier assets. At the same time, they created an expectation among market participants that the Fed would step in whenever markets experienced turbulence.

Already last year, Bessent argued that the Fed’s excessive purchases of government bonds blurred the boundary between monetary and fiscal policy and encouraged poor fiscal discipline.

Kevin Warsh has described the current situation—in which the Fed acts as a major creditor to the U.S. government—as «fiscal policy in disguise.» In his view, this practice encourages rising debt levels and increases the danger of «fiscal dominance,» meaning persistent government pressure on the central bank to support public spending through purchases of government bonds. Correspondingly, U.S. government debt has expanded dramatically.

The inflation of asset prices by the central bank has negative effects on economic growth because stock prices can rise even without gains in efficiency. Bessent concluded that the expansion of the Fed’s balance sheet primarily benefited Wall Street at the expense of Main Street.

According to Warsh, the Fed has increased wealth inequality by driving asset prices sharply higher through balance-sheet expansion. The share of total net wealth held by the richest 1 percent of Americans has risen from 27.9 percent in 2000 to 31.7 percent most recently. From this perspective, reducing the size of the Fed’s balance sheet becomes a central objective if the country is to be reunified, as promised in the MAGA agenda.

3. The New Treasury–Fed Accord and Its Risks

Kevin Warsh has proposed a “new Treasury–Fed Accord,” referencing the historic Treasury–Fed Accord of 1951. During World War II, the Federal Reserve was required to support the costly financing of the war effort. It suppressed interest rates by purchasing government bonds whenever private demand proved insufficient. In addition, it supplied commercial banks with ample liquidity so that they could purchase government bonds themselves.

Only in 1951 was the Fed released from its obligation to support U.S. government financing through bond purchases and artificially low interest rates. In this spirit, Warsh advocates a return to a more rules-based separation between monetary and fiscal policy.

Restructuring the Maturity Profile

Warsh has also suggested closer coordination between the Treasury and the Federal Reserve. The Treasury would issue more short-term Treasury bills, while the Fed would restructure its holdings of U.S. government securities in favor of shorter-term instruments.

Long-term interest rates would once again be determined more strongly by market forces, while the Fed would regain control over the short end of the yield curve. This would result in a steeper yield curve. Warsh has also called for the Fed’s “withdrawal” from the U.S. housing market by reducing its enormous holdings of mortgage-backed securities (MBS).

Following the U.S. mortgage crisis, policy rate cuts pushed short-term interest rates to zero, while the Fed’s balance-sheet expansion compressed long-term rates. Compared with 2002, the entire yield curve was lowered and flattened.

The sharp policy rate increases implemented in response to rising inflation since 2022 have pushed up the short end of the yield curve. Long-term rates, however, remain below their 2002 levels despite significantly higher public debt and inflation. A steeper yield curve would imply lower policy rates and higher long-term rates, consistent with Warsh’s concept of “QT-for-Cuts.” Short-term interest rates could decline if the Fed simultaneously reduces its enormous balance sheet, including through active sales of mortgage-backed securities.

Neither Scott Bessent nor Kevin Warsh has yet presented concrete proposals regarding the pace or magnitude of balance-sheet reduction. This likely reflects a desire to avoid having risks priced into financial markets prematurely and erratically.

The U.S. government is heavily indebted and faces substantial interest expenses. A reduction in the Fed’s asset holdings would decrease commercial bank deposits at the Fed, thereby increasing liquidity risks within the banking system.

Selling large volumes of mortgage-backed securities also carries risks, particularly through rising interest rates on politically sensitive mortgage loans. Higher long-term rates would increase borrowing costs for corporate investment and could ultimately contribute to a long-term structural crisis in the U.S. economy.

4. Measures to Counter the Risks of Balance-Sheet Reduction

The greatest obstacle to balance-sheet reduction is likely the high level of U.S. public debt, which has risen to USD 39 trillion as a result of persistently expansionary monetary policy and entails annual interest costs of roughly USD 1.2 trillion.

Before quantitative tightening began in 2022, the Federal Reserve held around 25 percent of outstanding U.S. government debt. Today, that figure stands at approximately 14 percent. As monetary policy tightened, the yield on 10-year U.S. Treasury bonds increased from 1.6 percent in December 2021 to roughly 4.5 percent today, creating substantial additional interest burdens for the federal government.

It is therefore likely that a further reduction in the Fed’s balance sheet would raise debt-servicing costs for the U.S. government and further undermine the international credibility of the dollar as the world’s leading reserve currency.

The share of short-term securities (maturities of up to one year) in outstanding federal debt currently exceeds 30 percent. As a countermeasure to rising interest expenses, the U.S. government can replace higher-yielding long-term debt with lower-yielding short-term debt, particularly if short-term interest rates decline.

The Fed Shortens Maturities

Since December 2025, the Federal Reserve has been purchasing short-term Treasury bills while allowing longer-term bonds to mature. In doing so, it has shortened the average maturity of its holdings. Stronger private demand for short-term Treasury bills could emerge if U.S. banks hold more of these securities as liquidity reserves.

The GENIUS Act stipulates that stablecoins issued by U.S. financial institutions must be backed by safe and highly liquid assets—primarily short-term Treasuries. Given the likely strong international demand for stablecoins, foreign investors could once again contribute to financing U.S. government debt at relatively low interest rates.

According to Scott Bessent, the reduction of the Fed’s holdings of mortgage-backed securities should be offset by corresponding purchases by the Treasury. Nevertheless, if the Fed’s balance sheet is reduced, the U.S. debt burden is unlikely to remain sustainable unless additional progress is made in reducing government spending.

The U.S. budget deficit still amounts to approximately 6 percent of GDP. Social spending, interest payments, and defense expenditures are difficult to cut. The war with Iran has created additional risks. Savings from reducing public-sector employment are substantial but continue to face legal obstacles.

On the positive side, U.S. economic growth remains comparatively strong relative to other industrialized nations. Growth is supported by tax cuts and reductions in welfare spending associated with the Big Beautiful Bill. As a result, nominal economic growth currently exceeds government borrowing costs, helping to keep the debt-to-GDP ratio under control.

Looser Rules for Banks

The sale of government bonds and mortgage-backed securities by the Fed would reduce the large reserves commercial banks currently hold at the central bank, potentially causing turbulence in the interbank market. According to Anderson et al., liquidity requirements for banks could be relaxed, and Treasury bills could be recognized as equivalent substitutes for central-bank reserves. Banks should also be able to refinance themselves more easily through the Fed’s discount window.

Furthermore, commercial bank reserves at the Fed could be remunerated differently—for example, by distinguishing between required and excess reserves—in order to make excessive reserve holdings less attractive. Experts estimate that regulatory adjustments alone could allow the Fed to shrink its balance sheet by approximately USD 1.2 to 2.1 trillion. In addition, the Fed is currently planning to ease bank capital regulations, thereby creating additional room for lending.

The risk of rising long-term interest rates for the corporate sector nevertheless remains. On the one hand, corporate insolvencies could increase. On the other hand, higher financing costs may encourage firms to improve efficiency. Warsh’s strong emphasis on «productivity-oriented growth» is said to favor highly efficient technology companies over speculative “moonshot” start-ups.

Artificial intelligence offers substantial productivity gains across broad sectors of the economy. These gains may be better realized in an environment of higher interest rates. AI-driven productivity improvements would help bring companies’ intrinsic values closer to stock prices that may currently be overvalued.

5. Outlook

The appointment of Kevin Warsh as the new Chairman of the U.S. Federal Reserve marks a turning point in terms of communication and policy orientation. The view that prevailed under Jerome Powell—that the central bank can and should stabilize the economy and financial markets during virtually any crisis through balance-sheet expansion—is being rejected.

The strategy for reducing the Fed’s balance sheet appears well-founded and forward-looking in terms of both its objectives and its anticipation of potential risks. This points toward greater central-bank independence. The stable and competence-oriented appointment process that brought Kevin Warsh to office signals that the Trump administration knows what it wants and how it intends to achieve it.

After the yield curve remained very flat despite the interest-rate increases implemented since 2022, the administration now seeks to restore a steep yield curve similar to the one that existed before the four rounds of quantitative easing conducted between 2008 and 2022.

By reducing its balance sheet, the Fed would lower long-term inflation expectations and regain greater flexibility in combating inflation. Warsh’s preferred inflation measure—the “trimmed mean inflation” rate—would exclude the most extreme price movements from the consumption basket, both on the upside and the downside. This would support a more long-term-oriented approach to monetary policy. Whether Kevin Warsh will ultimately be able to implement his agenda remains uncertain.

Although Warsh now serves on the Federal Reserve’s Board of Governors, only three of the seven board members were appointed by Republican presidents: Warsh himself, Michelle Bowman, and Christopher Waller. The remaining four members were appointed by Democratic presidents.

Jerome Powell’s unusual decision to remain on the Board of Governors after the end of his term as Chair suggests that there is an ongoing policy dispute within the board. Republicans are unlikely to gain a majority on this key governing body before January 31, 2028, when Powell’s official term expires.

Furthermore, it remains unclear how the majority of regional Federal Reserve Bank presidents within the Federal Open Market Committee (FOMC) will position themselves on these issues. While key decision-makers at both the Federal Reserve and the U.S. Treasury have acknowledged the limits of permanently expanding the Fed’s balance sheet, similar debates are not yet visible in other major currency areas such as Japan and the euro area.

Instead, it is reasonable to assume that structurally expansionary monetary policies will continue in both Japan and the eurozone, while the United States seeks to stabilize the dollar. This would not only strengthen the dollar’s leading international role but could also attract capital inflows into the United States, thereby supporting the banking sector, capital markets, the broader economy, and economic growth.

* Gunther Schnabl and Tom Bugdalle are members of the Flossbach von Storch Research Institute