Economist proposes smaller Fed balance sheet to cut bank subsidies

Chris Hughes, a former Federal Reserve official, has outlined a new monetary policy framework called Elastic Reserves that would allow the central bank to operate with a significantly smaller balance sheet. The proposal suggests reducing the Fed's asset holdings from approximately $6.7 trillion to around $4.5 trillion by changing how liquidity is supplied to commercial banks.

Under the current Ample Reserves system, the Fed pays banks higher interest rates on reserves than banks pay depositors, creating a subsidy for bank shareholders. Hughes argues that this large portfolio also artificially inflates prices for Treasury and mortgage-backed securities and exposes the Fed to political pressure. The new system would let banks determine reserve supply through borrowing needs rather than holding a fixed, large buffer.

The plan involves three lending programs, including a redesigned Standing Repo Facility and a new Term Liquidity Facility that would accept a broader range of collateral, such as business loans and mortgages. These changes aim to reduce the Fed's influence in financial markets while preserving its ability to control interest rates and ensure banking system liquidity.

Read the full story at brookings.edu.