The Ultimate Playbook for Reducing The Fed’s Balance Sheet | Professor Darrell Duffie on 4 Tools For Federal Reserve To Shrink Reserve Demand In Banking System

**Jack Farley** (0:00)
Today's episode is brought to you by the Fundrise Income Fund. You'll hear more about the Income Fund later in the show, but for now, let's get into today's interview. The new Fed Chair, Kevin Warsh, has made it no secret that he prefers a smaller Federal Reserve Balance Sheet, perhaps a much, much smaller Federal Reserve Balance Sheet. The consequences of this range from the mundane to the profound. But what is without question is that in order to reduce the Fed's balance sheet, there needs to be additional tools. I was able to interview someone who's the most in-demand expert on this topic. Professor Darrell Duffie just wrote a paper proposing four techniques the Fed can use in order to reduce the demand of reserves, thereby allowing it to reduce its assets. If the Fed were to try and reduce its balance sheet drastically without addressing the very high demand for reserve balances from the banking system, then there could be a flare up in funding markets such as the one we experienced in September 2019 or during the fall of 2025
I think the Federal Reserve has a very responsible institution that's very unlikely to happen. So if in several years or perhaps even a decade, the Federal Reserve's balance sheet is much, much smaller, I think it is highly likely that the Fed will use one or some, or perhaps all of the techniques proposed in this ground breaking paper. I have to say that this interview with Darrell Duffie is very complex, much more so than our first interview. And when preparing and conducting this interview, there were many times when I was very confused. So if you feel like that, please do not be intimidated. I bet there will be economic PhDs watching this, and you are going to watch it twice, just so they fully understand this. And we will, of course, include that paper called The Payment System Puts a Floor on the Fed's Balance Sheet, as well as another paper by Darrell Duffie. Let's get into it. We have a very important conversation today. I'm joined once again by Darrell Duffie, Distinguished Professor of Management and Professor of Finance at the Stanford Graduate School of Business, as well as the Department of Economics.
Professor, welcome to Monetary Matters. Good to see you again.

**Darrell Duffie** (2:15)
Great to be back with you, Jack.

**Jack Farley** (2:16)
I today want to talk about a very specific topic, and I'm going to set the stage a little bit. So we have a new Chair of the Federal Reserve, Kevin Warsh. He has stated a desire to reduce the Fed's balance sheet, something that has been going on since 2022
The issue is that that is a very difficult thing to do. And basically, the Fed's balance sheet bottomed last year at, let's see where we are, about 6.5 trillion dollars, which sounds, you know, is a huge number. And since then, it's been very, very modestly growing. And the question is, how is the Federal Reserve going to continue to shrink its balance sheet? And you are on the cutting edge of making some suggestions about how the Fed is going to do that. You have four ideas. Before we get into those four ideas, could you just continue to set the stage for me and for our audience? Why is it that the Fed has had such difficulty getting below the so-called LCLOR or the Lowest Comfortable Level of Reserves? What are we talking about here?

**Darrell Duffie** (3:26)
Terrific. You framed it with excellence, Jack, as usual. So in the popular discussion of the Fed's balance sheet size, most people are focusing on the assets. How much of these $6.5 trillion of assets does the Fed really need to hold, and couldn't it get rid of some of these assets without blowing up the economy?
Actually, that's not the right way to look at it. We should move over to the other side of the balance sheet where the liabilities are, because the assets by definition have to be at least as large as the liabilities, and it's really hard to squash down the Fed's liabilities, as it turns out.
So even if the Fed didn't want to own any of those assets, it has to own enough to support the liabilities, and some of them you just can't get rid of, like paper currency. What do you do? Do you go out and ask people to give back their paper currency? I don't think that's going to work, and there's $2.5 trillion of paper currency. So that kind of sets a baseline right there, and as we go through this discussion, I'm just basically going to walk through how one would reduce the need for the Fed's liabilities. You can't simply sell assets today and avoid problems because all of the liabilities on the Fed's balance sheet are serving very important roles. So if I can, just let me walk through briefly what those are, at least the big ones, and then we'll come back to where there is scope over time to reduce the need for one of those liabilities, which is reserve balances or the deposits of commercial banks held at the Fed. So let's set the stage. If there's 6.5 trillion of assets, there's got to be 6.5 trillion of liabilities. I've already said you can't do much with 2.5 trillion of those, which is paper money.