Monetary policy and bank regulation are two sides of the same coin. Since private banks create money through lending, any regulatory action (like changing capital requirements) directly influences the money supply. Giving the executive branch control over regulation would undermine an independent monetary policy.

Beyond its stated goals of employment and price stability, the Fed's recent aggressive asset purchases show its primary role is often to ensure smooth market functioning, making it dependent on market signals.

Current repo market stress is a structural problem caused by tight bank regulations, not a simple liquidity issue. To effectively shrink its balance sheet (QT), the Fed must first ease capital requirements. This counterintuitively acts as a nominal growth impulse by freeing banks to lend.

The post-Powell Fed is likely to reverse the QE playbook. The strategy will involve aggressive rate cuts to lower the cost of capital, combined with deregulation (like SLR exemptions) to incentivize commercial banks to take over money creation. This marks a fundamental shift from central bank-led liquidity to private sector-led credit expansion.

New Fed Chair Kevin Warsh has a path to reduce the Fed's balance sheet beyond direct asset sales (QT). By working with the Treasury to reform bank liquidity requirements, such as the supplementary leverage ratio, banks would need to hold fewer reserves. This naturally shrinks the Fed's liabilities and overall balance sheet size.

While monetary policy gets the headlines, the Fed's role as the key regulator of the financial system—influencing bank capital, liquidity, and lending practices—arguably has a more direct and significant influence on the real economy than interest rate decisions.

A new Fed Chair advocating for a smaller balance sheet cannot simply sell assets without causing market volatility. The Fed must first implement complex, long-term regulatory changes to reduce commercial banks' demand for reserves. This involves coordination with the Treasury and is not a quick policy shift.

The Federal Reserve has more flexibility to cut rates without stoking inflation if it is simultaneously shrinking its balance sheet. The two actions offset each other, meaning the Fed can provide economic stimulus via rate cuts while concurrently tightening through balance sheet reduction.

A potential Fed strategy involves cutting short-term rates while shrinking the balance sheet (selling long-term bonds). This appears hawkish, but deregulating banks allows them to use leverage to buy the Treasuries the Fed sells, effectively hiding QE on bank balance sheets.