Brookings Proposal Outlines Conditional Path to $4.5 Trillion Fed Balance Sheet
Key Facts
Chris Hughes outlined an illustrative path to shrink the Federal Reserve's balance sheet from about $6.7 trillion to about $4.5 trillion in a paper published by Brookings on October 19, 2026. The proposal involves moving to an "elastic reserves" system while maintaining control over interest rates and meeting banks' liquidity needs. The ultimate size of the balance sheet would depend on banks' actual needs, as part of reforms to the framework for reserve provision, regulation, liquidity and payments. Under Hughes' proposed system, reserves expand when banks borrow from the Fed and contract when they repay those loans. Private funding remains banks' primary source of financing, while elastic central bank lending allows them to meet their needs on demand.
The proposed design includes a new term liquidity facility offering 4-month loans through weekly auctions, according to Hughes' paper. Eligible collateral includes corporate loans and mortgages, broadening the range of assets banks can use to obtain funding. The design aims to expand regional and community banks' participation in Fed lending facilities. Hughes recommends that banks pre-position collateral at the facility so they are ready to borrow when liquidity is needed. He also calls for regular tests of their borrowing capacity, alongside preparation of the collateral underpinning access to funding.
Hughes estimates that bank reserves could settle near $1 trillion under this system, with banks retaining what they need for payments and safety buffers. In proportion to the decline in interest-bearing reserves, the paper estimates that interest payments to banks would fall by about two-thirds. The proposal also includes redesigning the standing repo facility to provide overnight reserves. These reserves would be supplied against Treasury securities and government-backed securities, providing banks with a short-term funding channel. The facility's borrowing rate would be slightly above the interest rate paid on reserves, under the design presented in the paper.
For monetary policy implementation, the paper recommends operationally targeting the Secured Overnight Financing Rate instead of the effective federal funds rate. It proposes limiting the Fed's permanent portfolio to short-term Treasury securities, while gradually shedding long-term bonds and mortgage-backed securities. For the Fedwire funds transfer system, Hughes calls for adding a liquidity-saving mechanism that would allow offsetting payments to be settled using fewer reserves during the day. He links achieving a sustainably smaller balance sheet to both developing lending facilities and implementing reforms that reduce demand for reserves. The paper describes these approaches as "necessary complements" within Hughes' proposed package of changes to the operating framework.
The Fed had announced that it would stop shrinking its securities portfolio effective December 1, 2025, according to its statement on monetary policy normalization. The announced arrangement called for reinvesting principal payments from agency securities in Treasury bills. The central bank said it would "cease the runoff of its securities holdings," setting the course for portfolio management at the time. The Federal Reserve Bank of New York later explained that purchases of short-term securities began after reserves reached an ample level. Those purchases aimed to "maintain an ample supply of reserves on an ongoing basis," according to the bank.
Balance sheet reduction faces warnings about banks' demand for liquidity and their funding costs, as part of the debate Brookings is publishing on alternative operating frameworks. Darrell Duffie warned that reducing the balance sheet requires lowering banks' demand for reserves. Duffie linked a failure to address that demand to the risk of "severe disruptions in money markets." In an earlier discussion, Donald Kohn and William English opposed the alternatives Hughes and Younger had proposed to the ample-reserves system. They argued that those alternatives could impose an "implicit tax on the banking system" and increase the cost of financial intermediation.
Meanwhile, the Fed's Balance Sheet Policy Working Group is reviewing the costs, benefits and risks of the ample-reserves system, according to the central bank. The review covers the composition of the Fed's portfolio, alongside an assessment of alternative monetary policy operating frameworks. Karen Dynan, Raghuram Rajan and Jeremy Stein lead the group, according to the Fed's announcement. Its mandate includes studying alternatives for how monetary policy is implemented and operated. The next Federal Open Market Committee meeting is scheduled for October 27 and 28, according to the Fed's meeting calendar.