Jerome Powell knows the Fed’s balance sheet got too big—Kevin Warsh has a plan, he just has to sell it without freaking out the markets

When Jerome Powell looks at the Federal Reserve’s balance sheet, he doesn’t need critics to tell him it expanded to historic proportions. He lived it. From the pandemic panic of 2020 to the inflation surge that followed, the Fed’s asset holdings ballooned from under $4 trillion to nearly $9 trillion at their peak. The central bank bought Treasury securities and mortgage-backed bonds at a pace never before attempted, stabilizing markets but permanently altering the scale of its footprint.

Now the bill for that intervention is coming due—not in losses alone, but in credibility, political scrutiny, and structural complexity. Powell has already begun shrinking the balance sheet through quantitative tightening (QT), allowing bonds to mature without reinvestment. But the process has been slow, cautious, and frequently interrupted by financial tremors. The message is clear: the Fed wants a smaller balance sheet, but it fears destabilizing markets more than it fears being large.

Enter Kevin Warsh, who has made the case that the Fed needs not just incremental shrinkage, but a philosophical reset. Warsh, a former Fed governor and longtime critic of post-2008 monetary excess, argues that the central bank’s vast holdings distort financial markets, blur the line between fiscal and monetary policy, and weaken the Fed’s inflation-fighting credibility. His plan is conceptually simple: normalize faster, clarify the destination, and restore scarcity to reserves. The challenge is psychological, not mathematical. He has to persuade markets that smaller does not mean unstable.

How the Balance Sheet Got So Big

The Fed’s balance sheet exploded in two major waves. The first followed the 2008 financial crisis, when quantitative easing became a central tool to lower long-term interest rates. The second wave, far larger and faster, came during the COVID shock. With financial markets freezing and economic activity collapsing, the Fed stepped in as buyer of last resort—not just for Treasurys, but for mortgage bonds and even corporate credit via emergency facilities.

At the time, the expansion seemed justified. Liquidity returned, borrowing costs fell, and panic subsided. But once inflation surged in 2021 and 2022, critics began asking whether the Fed’s enormous asset holdings contributed to excess liquidity and delayed policy tightening. Even if balance sheet growth did not directly cause inflation, it amplified the perception that the Fed had become overly reliant on extraordinary tools.

Powell has acknowledged that the balance sheet is larger than ideal in the long run. Yet the Fed operates under a framework adopted in 2019 that envisions “ample reserves”—a banking system flush with liquidity to prevent funding stress. That means the balance sheet will remain structurally bigger than before 2008. The debate now is not whether it shrinks, but how far and how fast.

Warsh’s Case for Going Further

Warsh’s critique rests on three pillars.

First, he argues that a massive balance sheet entangles the Fed in fiscal politics. When the central bank holds trillions in government debt, it effectively finances deficits. That perception risks political backlash and challenges the Fed’s independence.

Second, he believes large-scale asset holdings suppress market signals. If the Fed is a dominant buyer in Treasury or mortgage markets, price discovery weakens. Risk premiums compress artificially. Investors come to rely on a persistent backstop.

Third, Warsh contends that normalization itself restores discipline. Scarcer reserves force banks to manage liquidity more carefully. Financial markets must function without assuming constant central bank absorption of supply.

His implied prescription: define a clear end-state balance sheet tied closely to transactional demand for reserves, communicate a predictable runoff path, and avoid pausing QT at the first sign of volatility.

It sounds straightforward. It is not.

The Market’s Hair-Trigger Sensitivity

Financial markets have been conditioned for over a decade to interpret balance sheet shrinkage as tightening—even beyond interest rate hikes. The 2013 “taper tantrum” and the 2018 funding market stress remain cautionary tales. In both cases, the Fed signaled reduced asset purchases or continued runoff, and markets reacted sharply.

The lesson internalized by policymakers was simple: move slowly.

Warsh’s approach risks reawakening those memories. If investors fear that reserves will become scarce too quickly, short-term funding markets could spike. Treasury yields could rise abruptly. Equity valuations—already sensitive to liquidity conditions—could wobble. The irony is that the more clearly Warsh articulates his determination, the more markets might test it.

That is why selling the plan matters as much as designing it.

The Communication Challenge

Powell has mastered the art of gradualism. His