Kevin Warsh’s real Fed ‘regime change’ may happen deep inside Wall Street’s

Incoming Federal Reserve Chair Kevin Warsh‘s talk about “regime change” at the central bank has generated speculation about everything from interest rates to major personnel changes to fundamental alterations in the way it operates and communicates.

But what that eventually might look like is subtler though perhaps more consequential – a rethink of how the Fed manages the financial plumbing in the U.S. economy and the mammoth balance sheet it has built through some 18 years of crisis fighting.

Interviews with former Fed officials and economists, along with a growing library of research, suggest Warsh could guide the Fed to a smaller role in day-to-day financial markets, while also setting clearer rules for how and when it should intervene.

Simply stated, the debate centers on whether the Fed should continue using its balance sheet as a regular tool for influencing financial conditions and supporting markets — as it has through much of the post-financial crisis era — or reserve it for periods of market dysfunction and more pernicious economic stress.

The debate over the $6.8 trillion balance sheet is technical in nature and tucked away from the more common discussions about Fed policy. But the stakes are substantial.

Since the financial crisis that exploded in 2008, the Fed has aggressively used its holdings of Treasurys and mortgage-backed securities to stabilize markets and influence broader financial conditions.

Prior to the crisis, the Fed had a minuscule balance sheet relatively speaking – about $800 billion – but expanded it at one point to about $9 trillion. The Fed’s asset holdings now equate to about 23% of the U.S. economy, or some seven times where they were pre-financial crisis.

Any effort to change the system could have wide ramifications, potentially impacting Treasury yields, mortgage rates and other interest-sensitive areas of the economy, while influencing the way policymakers respond to future crises.

“It’s a debate we’re going to be seeing later this year. But one thing that’s encouraging about all of this is that nobody, including Kevin Warsh, is arguing that any of this could be done rapidly,” said Lou Crandall, chief economist at Wrightson ICAP and a longtime Fed watcher.

“It’s got to be done carefully, and some of the changes … would probably take time to implement,” he added. “Everyone’s looking at this as a medium-term project rather than part of the day-one agenda.”

Warsh called the balance sheet, in a Wall Steet Journal op-ed piece last year, “bloated” and said it could be reduced while at the same time allowing the Fed to lower interest rates.