In his latest remarks on Tuesday, U.S. Treasury Secretary Bessant made no secret of his intention to "reform" the Federal Reserve, a statement that quickly drew significant attention from the industry.
Bessant stated that a core issue he raised during his interviews for the next Federal Reserve chairman was simplifying the Fed's operations. He pointed out that the Fed had become overly complex in managing the money market.
“One of the criteria I use to evaluate candidates is their focus on the coordinated operation of the Fed’s various policy tools. I recognize that the Fed has evolved into an extremely complex operating system,” Bessant said.
Bessant explained, "The Federal Reserve is leading us into a new era of so-called 'ample reserve regimes,' but current banks... " The question of whether reserves are truly sufficient appears to be gradually revealing cracks.
The Federal Reserve is currently employing a so-called "ample reserve" strategy in controlling policy interest rates, which includes holding a large amount of Treasury bonds on its balance sheet. As part of its current operating mechanism, the Fed pays interest on bank reserves held at the Fed, as well as on cash temporarily held by money market funds at the Fed.
Bessant did not specify the meaning of the so-called "crack." However, the Federal Reserve has indeed been facing a persistent liquidity crunch in the money market recently, which is closely related to the way the central bank currently manages its $6.56 trillion balance sheet and the level of liquidity in the financial system.
To ensure ample liquidity, Federal Reserve policymakers decided last month to halt balance sheet reduction starting December 1. Since June 2022, the Fed has been continuously shrinking its asset portfolio, including its holdings of Treasury securities and mortgage-backed securities during the COVID-19 crisis. Its scale once saw a historic surge.
Bessant stated, "There are currently numerous financing tools and operating mechanisms available, including the Standing Repo Facility (SRF), and I believe we need to simplify these operations." However, he did not specify how the central bank should reform the existing operating mechanisms.
The SRF mechanism allows eligible institutions to borrow cash using government bonds and agency bonds as collateral. This mechanism has been frequently used by the industry recently, with usage reaching $50.4 billion on October 31 – the highest figure since the tool was made permanent in 2021.
A major overhaul is urgently needed.
Bessant has long been a critic of the Federal Reserve, particularly concerned about its massive balance sheet, which currently consists mainly of trillions of dollars in bonds, most of which were purchased by the Fed in its early years to stabilize financial markets and stimulate the economy.
Bessant and critics, including those within the Federal Reserve, argue that this massive asset size is distorting market pricing. Furthermore, concerns have been raised about the complex way the Fed manages interest rates through liquidity tools—a system that abandons the highly controlled approach used nearly two decades before the financial crisis.
In fact, there has been some criticism within the Federal Reserve regarding its bloated balance sheet. Kansas City Fed President Jeffrey Schmid stated in a speech on November 14th that "the massive balance sheet expands the Fed's influence in financial markets, distorts duration prices and the slope of the yield curve, and may blur the lines between monetary and fiscal policy."
Some industry observers have also noted that the current liquidity management system is forcing the Federal Reserve to pay huge sums of money to financial institutions. This practice has turned the Federal Reserve from a once highly profitable central bank into an institution that is now losing as much as $240 billion—although these losses do not affect its operational capabilities.
However, despite the complexity of the current system's structure, it still enjoys broad support from Federal Reserve policymakers —largely because most of its functions are currently automated, requiring less frequent intervention than the pre-financial crisis system. At the same time, Fed officials warn that any move to terminate the current system would trigger significant upheaval, as it would require the Fed to sell off large amounts of its holdings of Treasury bonds and mortgage-backed securities, leading to a sharp rise in real borrowing costs.
"It's time for the Federal Reserve to step back."
Bessant noted on Tuesday, "There are extremely complex trade-offs between monetary policy, balance sheets, and regulatory policy, and we've emphasized this in our (Federal Reserve Chairman) interviews—how exactly do these interact?"
The U.S. Treasury Secretary also stated, "I think it's time for the Federal Reserve to step back," but he did not specify what measures this would involve.
Bessant also suggested that central bank officials might be speaking too frequently. "We need to curb the redundant statements from these regional Fed presidents," Bessant said—his remarks seemingly directed primarily at the regional Fed presidents who are currently giving more public speeches, rather than at the Fed governors.
He hinted at disagreements over the appointment of some regional Federal Reserve presidents. “These regional Fed presidents should have come from within their districts,” Bessant noted, “but at least three or even four regional Fed presidents were hired from outside their districts. They don’t even live in their districts and commute to New York every day.”
As is well known, the Federal Open Market Committee (FPMC), responsible for setting interest rates, consists of seven governors and five regional Federal Reserve presidents—the other four seats rotate annually, except for the president of the New York Federal Reserve. Unlike governors, regional Federal Reserve positions do not require White House nomination or Senate confirmation.
However, the re-election of regional Federal Reserve presidents is subject to a review process by the Federal Reserve Board of Governors every five years, with the next review scheduled for February next year. **As early as August, Cailian Press reported that if a majority of the Federal Reserve Board members wished, they could remove some or all of the regional Federal Reserve presidents by the end of February next year—although this has never happened before in the history of the Federal Reserve…**
This related risk has since been mentioned multiple times by prominent journalist Nick Timiraos, who has been dubbed the "new Fed's mouthpiece."
Bessant also noted on Tuesday that "Federal Reserve governors currently appear to favor rate cuts."
When asked about Trump's earlier suggestion this month that he would fire the Treasury Secretary if he did not help lower interest rates, Bessant responded, "If you were there, you would know he was joking."
(Article source: CLS)
