In many ways, Milton Friedman's ideas were avant-garde and helped shape modern monetary economics. In his famous 1967 AEA Presidential Address, Friedman introduced the natural rate hypothesis and argued that inflation expectations ultimately limit the ability of monetary policy to influence real economic activity. This insight laid much of the intellectual foundation for modern central banking. Friedman was also an early advocate of large scale asset purchases, as evidenced by his call in 2000 for the Bank of Japan to do QE to end Japan’s deflation. He further anticipated modern thinking on monetary transmission by embracing the portfolio balance channel long before it became vogue. And while Friedman never explicitly advocated NGDP targeting, he eventually came to view “the broadest framework . . . of the work that I and others have done in analyzing monetary experience” as a “theory of nominal income,” a perspective that many proponents of NGDP targeting, like myself, also share.

Another example of Friedman's ability to anticipate future developments can be found in his 1969 essay The Optimum Quantity of Money. In it, Friedman argued that the opportunity cost of holding money should be driven to zero so that households and firms do not inefficiently economize on liquidity. Put differently, Friedman viewed the opportunity cost of holding money as a form of implicit tax on liquidity. The higher this tax, the greater the incentive to devote real resources toward avoiding money holdings.

This understanding became known as the Friedman Rule. Advocates of the ample reserve system often invoke it as a justification for maintaining a large Fed balance sheet while paying interest on reserve balances at market rates. Former Fed Chair Ben Bernanke recently made this point at a Brookings conference when asked about the size and importance of the Fed’s balance sheet:

[I]t should be big, again on good economics, because it’s a very good way to manage the short-term interest rate and assure that banks have enough reserves. And that’s a good thing for financial stability.

It’s a good thing. Milton Friedman would like it because it keeps the cost of transactions low. You know, money should have a zero opportunity cost and all those things… So I think, from an economic point of view, that the balance sheet is pretty much okay where it is.

As a fan of Milton Friedman, I am sympathetic to this argument. It captures an important insight. If liquidity is taxed, households and firms will devote real resources toward avoiding it. Good monetary policy should seek to minimize those costs.

However, applying the Friedman Rule to the Fed’s balance sheet is more complicated than Bernanke’s remarks suggest. The Friedman Rule is fundamentally about the cost of liquidity, not the quantity of reserves. Yet advocates of the ample reserve system often move from the proposition that liquidity should not be taxed to the conclusion that the Fed should maintain a permanently large balance sheet. That conclusion does not necessarily follow.

In addition, the Friedman Rule is only one margin among many that should guide balance-sheet policy. The size of the Fed’s balance sheet also affects market structure, regulatory burdens, interbank lending, Treasury market functioning, central bank independence, and other considerations. Focusing narrowly on the opportunity cost of reserves risks missing the balance-sheet forest for the Friedman-rule trees, as illustrated above.

In this newsletter, I explain why this is the case. I begin by showing how an ample reserve system can satisfy the Friedman Rule and why, at times, it may fail to do so. I then consider alternative ways to satisfy the Friedman Rule before turning to the broader set of tradeoffs that should also inform the size of the Fed’s balance sheet.

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Satisfying the Friedman Rule with Ample Reserves

To illustrate how an ample reserve system can satisfy the Friedman Rule, consider the equation below. It frames the opportunity costs of liquidity in terms of the potential tax on reserves borne by banks:

The first term, Market Rate – IORB, measures the opportunity cost of holding reserves rather than alternative safe assets. If reserves earn less than, say, Treasury bills, then banks face an implicit tax for holding liquidity. This spread can be viewed as the implicit tax rate on bank reserves.

The second term, Reserve Holdings, is the tax base. It measures the quantity of reserves on which this implicit tax is imposed. Taken together, the equation implies that the total tax burden for banks holding reserves depends on both the opportunity cost of reserves and the quantity of reserves held.

From this perspective, the Friedman Rule can be understood as a call to minimize the tax rate on bank reserves. If the Fed pays interest on reserves at a rate equal to the return on comparable safe assets, then the opportunity cost of holding reserves is zero. The implicit tax on liquidity disappears.

Enter the ample reserve system. Under this approach, the Fed supplies enough reserves to more than satiate banks' demand for liquidity while paying interest on those reserves at a rate comparable to other safe assets. In effect, the Fed floods the banking system with reserves, placing it on the flat portion of the reserve demand curve. That, in turn, pushes short-term market rates toward IORB. As a result, banks can hold reserves without sacrificing yield relative to other safe assets. From this perspective, the ample reserve system provides a practical implementation of Friedman's insight. It minimizes the opportunity cost of bank liquidity by using a large balance sheet to align market rates with the interest paid on reserves.

This is the argument Bernanke and other defenders of the ample reserve framework have in mind. If liquidity should not be taxed, then supplying ample reserves while paying a market rate of interest on them seems like a reasonable solution.

Violating the Friedman Rule with Ample Reserves

The Friedman-rule defense of the ample reserve system rests on a simple proposition: if reserves earn a market rate of return, then banks face no opportunity cost from holding liquidity. But this conclusion only follows if reserves are otherwise costless to hold.

The problem is that the post-GFC regulatory framework has reintroduced a tax on liquidity through a different channel. Even when reserves earn a market rate of interest, leverage requirements and other balance-sheet constraints can make them costly to hold.

To see this point, consider a slightly modified version of the reserve-tax equation introduced above:

The significance of this new term, Regulatory Cost(R), is that the ample reserve system may not always satisfy the Friedman Rule. The traditional argument assumes that paying IORB at a market rate eliminates the opportunity cost of holding reserves. But if expanding the Fed’s balance sheet also increases the regulatory costs associated with holding reserves, then the effective tax on liquidity does not disappear. It simply changes form.

An example of the Regulatory Cost(R) term is the Supplementary Leverage Ratio (SLR). It is a post-2008 regulation that requires large banks to hold a minimum amount of capital against their total assets, regardless of risk. The SLR treats reserve balances much like other assets on a bank’s balance sheet. Consequently, when the Fed creates reserves through QE, those reserves consume balance-sheet capacity even though they are risk-free assets.

The Federal Reserve itself implicitly acknowledged this reality in 2020 when it temporarily excluded reserve balances and Treasury securities from the SLR after a surge in reserves and deposits placed pressure on bank balance sheets. Notably, the exemption did not alter the interest paid on reserves. It reduced the regulatory cost of holding them.

This concern becomes even more important once one recognizes the ratchet effect associated with repeated rounds of QE. As shown by Raghuram Rajan and his coauthors, QE can create a form of liquidity dependence in which reserve demand rises alongside reserve supply and does not fully reverse when the Fed shrinks its balance sheet. Bill Nelson has pointed to a complementary channel: supervisory expectations regarding prudent liquidity management may also ratchet upward over time, leading banks to maintain larger reserve buffers than they otherwise would. These developments suggest a broader concern about a supply-driven ample reserve system. By continually accommodating elevated reserve demand—whether driven by liquidity dependence, supervisory expectations, or both—it may cause reserve balances and the Fed's balance sheet to grow faster than the underlying economy over time.

This possibility creates a deeper challenge for the Friedman-rule defense of ample reserves. If regulatory costs rise with reserve holdings, then a larger balance sheet increases both the quantity of reserves subject to the reserve tax and the effective tax rate itself. In that case, the very mechanism used to eliminate the tax on liquidity can gradually recreate it through the expansion of the Fed’s balance sheet.

More fundamentally, regulatory costs are only one consequence of maintaining a large balance sheet. As discussed later, the same large balance sheet that drives market rates toward IORB may also suppress interbank lending, create liquidity dependence, weaken lending to the real economy, and undermine the Fed's independence. This raises a broader question: are there other ways to satisfy the Friedman Rule without relying on permanently abundant reserves?

Other Ways to Satisfy the Friedman Rule

Fortunately, the Friedman Rule does not uniquely imply an ample reserve system. There are at least three alternative ways to reduce the tax on bank reserves without relying on a permanently large Fed balance sheet.

First, the Fed could aim to reduce reserve demand and operate with a smaller balance sheet. Much of the Friedman-rule defense of ample reserves focuses on reducing the opportunity cost spread (the tax rate) while holding reserve quantities (the tax base) constant. But the quantity of reserves is itself a policy choice. If banks can safely operate with fewer reserves, then shrinking the Fed's balance sheet reduces the quantity of reserves subject to the reserve tax. Recent calls by Darrell Duffie, Stephan Miran, Lorie Logan, Bill Nelson and others to reduce the structural demand for reserves point in this direction. While reducing reserve demand does not eliminate the importance of paying a competitive return on reserves, it does weaken the claim that a permanently large balance sheet is necessary to satisfy the Friedman Rule.

Second, the Fed could adopt a voluntary reserve-targeting regime, as recommended in a 2008 Fed staff study. Under this approach, banks would voluntarily choose reserve targets and earn a market return on reserve balances held within a band around those targets. This would eliminate the opportunity cost of liquidity while allowing the Fed to operate with a smaller balance sheet. It would also encourage the revival of interbank lending. Banks holding reserves above their target would earn a lower return on excess balances and therefore have an incentive to lend them to other institutions. Conversely, banks falling short of their target would have an incentive to borrow reserves rather than incur a penalty.

Third, the Friedman Rule can be approximated in a demand-driven operating system anchored by robust, business-as-usual ceiling facilities. If banks can obtain reserves on demand at rates close to market rates, then they need not hold large precautionary reserve balances (the tax base) and face little or no opportunity cost (the tax rate) in accessing liquidity when needed. In this framework, liquidity is not pre-funded through ample reserves. Instead, it becomes latently ample through reliable access to central bank facilities.

The broader point is that the Friedman Rule is often interpreted as an argument for abundant reserves. A better interpretation is that it is an argument for abundant liquidity. Once that distinction is recognized, demand-driven operating systems become a natural alternative to the ample reserve system.

Other Margins Matter Too

A final point is that even if an ample reserve system satisfies the Friedman Rule, it only addresses one margin in determining the optimal size of the Fed’s balance sheet. But the Fed’s balance-sheet policy is not a single-margin optimization problem. The Fed must weigh the benefits of reducing the opportunity cost of reserves against the costs that emerge elsewhere in the system. At least four additional margins deserve attention.

1. The Interbank Lending Margin

By supplying reserves in such abundance that banks have little need to borrow or lend reserves, the ample reserve system reduces the role of interbank funding markets in allocating reserves across institutions. Over time, interbank lending can atrophy weakening price discovery and market discipline. The tradeoff is straightforward: lower liquidity costs versus a diminished role for private liquidity redistribution. This margin has become a motivating factor for many central banks moving toward a demand-driven operating system.

2. The Liquidity-Fragility Margin

As noted above, Raghuram Rajan and his coauthors argue that QE can create a form of liquidity dependence in which reserve demand rises alongside reserve supply and does not fully reverse during QT. If so, ample reserves may not merely satisfy liquidity demand but help create it. The result is a financial system that becomes increasingly dependent on high reserve levels and a Fed balance sheet that tends to grow faster than the underlying economy.

3. The Bank-Lending Margin

Research by William Diamond and his coauthors find that large reserve injections can crowd out bank lending by raising the marginal cost of expanding bank balance sheets. To the extent that ample reserves encourage banks to hold more liquidity and rely on shorter-term funding, they may reduce incentives for the maturity transformation that underpins traditional bank lending to the real economy.

4. The Central Bank Independence Margin

A larger balance sheet may also create political vulnerabilities. Interest paid on reserves can be portrayed as a subsidy to banks, operating losses can invite criticism, and large asset holdings can blur the line between monetary and fiscal policy. As the Fed’s balance sheet grows, so too may the political pressures surrounding its use.

Taken together, these margins underscore the broader point of this essay. The Friedman Rule addresses an important question: how can the opportunity cost of liquidity be minimized? But it does not answer every question relevant to the size of the Fed’s balance sheet. The optimal operating framework must balance reserve efficiency against its effects on market functioning, liquidity fragility, bank lending, and central bank independence. Focusing on only one of these margins risks missing the balance-sheet forest for the Friedman-rule trees.

Conclusion

Ben Bernanke is right that the Friedman Rule offers an important insight: liquidity should not be taxed. But it does not follow that a permanently large Fed balance sheet is the only—or even the best—way to achieve that objective. As I have shown, an ample reserve system may not always satisfy the Friedman Rule once regulatory costs and balance-sheet constraints are taken into account. Moreover, even when it does, the Friedman Rule is only one margin among many that should guide balance sheet policy. Interbank lending, liquidity fragility, bank lending to the real economy, and central bank independence all deserve consideration as well. The broader lesson is that the Friedman Rule is best understood as an argument for abundant liquidity, not abundant reserves. Once that distinction is recognized, alternative operating frameworks become possible Put differently, the Friedman Rule identifies an important tree. Determining the optimal size of the Fed's balance sheet requires understanding the entire forest.

I recently sat down with my Mercatus Center colleague Tom Hoenig to discuss what to expect from the new Fed Chair, Kevin Warsh. Tom served as president of the Federal Reserve Bank of Kansas City from 1991 to 2011 and later as vice chair of the FDIC from 2012 to 2018. His tenure at the Federal Reserve overlapped with Kevin Warsh's service as a Fed governor, giving him firsthand insight into Warsh's approach to policymaking. Tom remains actively engaged in debates over monetary policy and financial regulation through his work at Mercatus.

Importantly, Tom was a voting member of the FOMC during the Fed chair transition from Alan Greenspan to Ben Bernanke in 2006, giving him a unique perspective on the challenges and opportunities facing a new Fed chair. We discuss the transition as well as other issues facing the Fed.

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The full video of my discussion with Tom Hoenig is posted above and highlights from it are listed below:

• Kevin Warsh inherits a difficult economic environment. Inflation remains above target, oil prices and geopolitical risks are rising, while growth and labor market conditions show signs of fragility. Balancing price stability and economic growth will be a major challenge from day one.

• Tom Hoenig reflected on witnessing Ben Bernanke become Fed Chair in 2006. Tom contrasted Ben Bernanke’s arrival with today’s environment, noting that FOMC members then operated within a stronger culture of supporting the chair. Kevin Warsh, by contrast, will need to build credibility and consensus within a more diverse and independent-minded committee.

• Leading the FOMC requires persuasion, not command. Tom explained how Fed chairs must absorb a wide range of views, formulate a policy direction, and convince committee members to support it. Kevin Warsh’s diplomatic skills will be tested immediately.

• The regional Federal Reserve Bank system remains a critical strength. Tom described how regional Fed presidents bring real-time information from across the country, creating a richer understanding of economic conditions and helping shield monetary policy from excessive political influence.

• Kevin Warsh is likely to challenge the Fed’s expanded role. Tom discussed Kevin Warsh’s concerns that the Fed has increasingly ventured beyond its traditional responsibilities, creating expectations that it will intervene whenever markets encounter stress.

• Kevin Warsh may rethink Fed communications. Tom suggested that Kevin Warsh is skeptical of forward guidance and the “dot plot,” arguing that these tools can create false certainty and distort market expectations.

• Federal Reserve independence faces mounting pressure. Our discussion explored how growing fiscal deficits, political expectations from the White House, and market demands for easier monetary policy could complicate the Fed’s ability to pursue its dual mandate independently.

• The fiscal outlook is becoming a monetary policy issue. We touched on how rising government debt could eventually limit the Fed’s policy options and increase pressure to monetize deficits. These fiscal pressures may also constrain Kevin Warsh’s desire to shrink the Fed’s balance sheet.

• The Fed-Treasury relationship could be redefined. A recurring theme we both observe is current Fed conversations is the need to clarify the distinction between Treasury debt management and Federal Reserve monetary policy, preserving the Fed’s focus on price stability.

• Crisis interventions should remain temporary. Tom noted that both he and Kevin Warsh support emergency liquidity measures during crises but are skeptical of extending extraordinary monetary policies long after economic recoveries have begun.

• The future of the Fed’s operating system. Our discussion also touched on whether the Fed can adopt a more demand-driven operating system, similar to that being pursued by other major central banks, and its implications for interbank lending and the size of the Fed’s balance sheet.

• Despite significant challenges, Tom Hoenig remains cautiously optimistic. Tom concluded that Kevin Warsh’s experience, judgment, and diplomatic skills give him a strong chance of navigating what could be one of the most consequential periods for the Federal Reserve in decades.

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One recurring topic on both the podcast and this newsletter has been the future of Fed master accounts. These are the accounts that allow financial institutions to settle payments directly with the Federal Reserve and, in turn, grant access to the Fed’s payment rails. Past podcasts where I have covered master accounts include episodes with Julie Hill, George Selgin, Senator Pat Toomey, and Dan Awrey.

Historically, only traditional banks have had access to master accounts, but over the past decade other nonbank firms have been seeking access too. The most prominent cases include The Narrow Bank in 2017, Reserve Trust in 2018, and Custodia and Kraken in 2020. Julie Hill provides a great overview of this history in this Yale Journal on Regulation article where she shows how access to Fed master accounts has become a major regulatory battleground.

This is why the Macro Musings podcast with David Zaring this week is so timely. Zaring, a legal scholar at the University of Pennsylvania, has been thinking hard about this exact problem: how should the regulatory system adapt when firms want to do only part of what banks traditionally do? In his recent paper, “Skinny Charters: Rebuilding the Banking Regulatory Perimeter,” Zaring argues that we should stop treating banking as an all-or-nothing category. Traditional banks take deposits, make loans, and process payments. But many new entrants do not want to do all three. Some want to process payments. Others want to provide custody services. Still others want to lend without taking deposits. So why force all of them into the same full-service bank charter?

Zaring’s proposal is to create more tailored, activity-specific charters—or “skinny charters”—that match regulation to the actual risks a firm creates. A payments firm like Stripe, for example, does not create the same maturity-mismatch risk as a traditional bank that funds long-term loans with runnable short-term deposits. So it may not need the full panoply of bank regulation. It would still need oversight, but the oversight would be tied to payments risk rather than to a loan book it does not have. That is the key point: regulate the activity, not just the institutional label.

As we discussed in the episode, the regulatory system is already moving awkwardly in this direction. The OCC has had a fintech charter concept for years, but no firm has actually received one. Instead, many fintech and crypto firms have looked to OCC trust charters or special-purpose state charters as a workaround. At the same time, the Fed has begun talking about “skinny” master accounts, which would provide limited access to Fed payment services for firms that are not traditional full-service banks. Kraken’s recent approval for a master account suggests that some version of this world may already be arriving.

And then there is the PACE Act, which we discussed as well. This proposed bipartisan bill would create a clearer path for large payment providers—firms such as PayPal, Cash App, Apple Pay, or Google Pay—to get access to Fed payment rails through an OCC-administered licensing regime. These firms would not become full banks. They would face restrictions: they could not fund loans with customer deposits or act like ordinary banks. But they would get a more direct route into the payments system, including access to Fed services and relief from navigating fifty different state regulatory regimes. In effect, the PACE Act would put congressional blessing behind the same basic idea now floating through the master-account debate: payment firms may deserve a separate regulatory lane.

Now, the PACE Act is only proposed legislation and may go nowhere. But even if PACE stalls, the broader point remains: the horse is already out of the barn. The debate over Fed master accounts, skinny charters, and direct access to the payment rails is no longer a niche fight among banking lawyers and fintech firms. The latest manifestation of this shift came after my conversation with David Zaring was recorded, when President Trump issued a new executive order that takes direct aim at these very issues. The order adds further momentum to the idea that payment firms may deserve a separate regulatory lane. Let’s now consider what exactly the executive order does.

President Trump Executive Order on Fed Master Accounts

President Trump’s executive order (EO) on May 19 requires federal financial regulators to review their “regulations, guidance, supervisory practices, and application processes” to see what could be updated to better support fintech firms. That review has to be completed within 90 days. Based on it, regulators then have 180 days to “take steps to encourage innovation.” The order’s stated goal is to reduce unnecessary barriers to entry and remove fragmented rules that often end up protecting incumbent financial firms.

The EO singles out the Federal Reserve among the federal financial regulators and asks the Board of Governors to evaluate the legal, regulatory, and policy framework governing access to Reserve Bank master accounts and payment services by nonbank financial companies.

The EO, as I read it, is pushing the Fed to answer several questions it has often preferred to handle quietly and on a case-by-case basis:

• Does the Federal Reserve Act allow broader access to Fed payment accounts?

• What legal barriers prevent nontraditional firms from getting direct access?

• What risk-management conditions would be needed if access were expanded?

• How much discretion do the twelve regional Reserve Banks have to approve or deny master account applications on their own?

That last point is important. The Custodia litigation, discussed in the David Zaring podcast above, puts a spotlight on the relationship between the Board in Washington and the regional Reserve Banks. Specifically, the EO is asking the Fed to clarify whether Reserve Banks can act independently in granting or denying access, and, if so, what Board-level rules exist or should exist to make sure applicants are treated consistently across the Federal Reserve System.

To be clear, the EO does not force the Fed to say “yes” to fintech firms. But it does make it harder for the Fed to maintain a master-account process that is opaque, slow, and highly discretionary. In effect, it pushes the Fed toward a more rule-like framework: clearer standards, clearer timelines, and clearer explanations for who gets access to the core plumbing of the dollar system.

That is a big deal. The Fed can still say no. But after this EO, it will face more pressure to say why.

Conclusion: Run Sandbox Experiments

Change is afoot on Fed master accounts. The question now is not whether the regulatory perimeter around payments will evolve, but how it will evolve. Ideally, this transition should occur in a measured and safe manner that balances innovation with financial stability concerns.

One conservative path forward would be to have each of the twelve regional Federal Reserve Banks run a sandbox-style experiment in which they each grant “skinny” Fed master accounts to a limited number of qualifying firms in their district. The firms could vary across payments, custody, and other narrowly defined financial activities. Likewise, the terms and supervisory approaches could vary somewhat across Fed districts. The point would be to allow experimentation, learn what works, identify risks early, and develop best practices before scaling up broader access across the Federal Reserve System.

If done well, this kind of experimentation could allow the Fed to modernize the payment system without compromising the stability and trust that make the dollar system work in the first place.

The U.S. economy has now experienced inflation above 2 percent for five consecutive years. The latest reading, the March headline PCE inflation, came in hot at 3.5 percent, raising concerns that inflation may no longer be well anchored. Some observers argue this uptick is temporary, reflecting one-off factors such as the Middle East conflict and tariffs. Others, however, see deeper forces at work: a gradual unmooring of inflation expectations, persistent fiscal pressures with deficits near 6 percent of GDP, and perhaps even a Federal Reserve that has been too slow to tighten policy.

So which is it? The textbook answer is straightforward: if elevated inflation is driven by temporary supply shocks and a credible nominal anchor remains intact, then it is largely benign. But if five years of above-target inflation, combined with the inflation scarring of the COVID era, has made households more sensitive to price increases, then one cannot simply assume a well-anchored economy that can easily see through the supply shocks.

In what follows, then, I will take a look at how well the U.S. economy is anchored. And I will do so by revisiting some of my favorite inflation indicators outside of the more common ones used by observers. Taken together, they paint a nuanced picture. American households remain deeply scarred by the inflation surge of the early 2020s and continue to watch prices far more closely than they did before the pandemic. Yet for all the concern, the broader nominal economy still appears anchored.

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Household Views on Inflation

One of the clearest signs that the inflation surge left a lasting imprint on the American psyche comes from the Gallup poll data. This can be seen in the chart below which compares the two components of the Fed’s dual mandate going back to the 1960s. Although not as high as it was in the 1970s, inflation continues to dominate unemployment as the more important problem.

The persistence of the inflation concern matters. Before the pandemic, inflation barely registered as a concern for most Americans. It was simply not something households spent much time thinking about. Today it clearly is.

This development is important because inflation expectations are partly psychological. Once households begin paying close attention to prices, they become more likely to notice every price increase at the grocery store, every jump in insurance premiums, and every rise in rent. The COVID inflation surge appears to have fundamentally changed how Americans process price movements.

Still, there is an important distinction between inflation scarring and outright deanchoring. The Gallup data suggest inflation remains a nagging concern, but not one that is steadily worsening. In other words, households appear permanently more sensitive to inflation than they were during the Great Moderation years, but there is little evidence that concern is spiraling upward into a self-reinforcing inflation psychology.

The same general story emerges from consumer inflation expectation surveys. The three household inflation expectation measures shown below all remain elevated relative to their pre-pandemic levels. On the surface, that could be interpreted as troubling news for the Fed. Elevated inflation expectations are often viewed as an early warning sign that the nominal anchor is slipping.

But there is another interpretation that fits the data. These elevated readings may simply reflect inflation scarring. Households experienced the largest inflation shock in forty years. It would be surprising if their expectations immediately reverted back to the calm and complacency that prevailed during the 2010s.

Importantly, these expectation measures have not been exploding upward. They remain elevated, but relatively stable. That distinction matters. A deanchoring process typically involves expectations drifting continuously higher as households and firms lose confidence in the central bank’s commitment to price stability. We do not clearly see that dynamic today.

Still, the inflation scarring discussed above means households continue to see inflation as the bigger risk, and that is something the Fed cannot ignore. This is seen in the chart below. Based on the above Gallup data, it shows a balance-of-risk perspective where the public remains more concerned about inflation than labor market weakness.

The Fed’s cautious stance on rate cuts is consistent with the balance of risk measure. Even if the economy remains broadly anchored, households are still highly sensitive to inflation developments, meaning any renewed flare-up in prices could quickly erode confidence in the Fed’s credibility.

So while the evidence does not point to a fully unanchored nominal economy, it does suggest the Fed cannot afford complacency.

Household Revealed Preferences

The previous section focused largely on surveys. But talk is cheap. A better test is whether households are actually behaving as if they fear inflation and nominal instability.

One of my favorite places to look for answers on this question are Google searches for inflation. The figure below shows that searches for inflation remain structurally higher than they were before the pandemic. Americans are simply paying more attention to inflation than they used to.

There was also a notable recent spike in inflation-related searches whose timing closely lines up with the Middle East conflict and renewed concerns over energy prices. However, that spike appears to be fading back toward this new higher baseline rather than continuing upward. That pattern again points more toward inflation scarring than full deanchoring.

Another revealing indicator comes from Series I savings bonds. These retail savings bonds are explicitly indexed to inflation through the CPI and therefore provide protection against rising prices. As the figure below shows, demand for Series I bonds surged during the pandemic period. Unsurprisingly, households scrambled for ways to protect their purchasing power during the 2021-2022 inflation surge.

The figure also shows that as inflation began moderating, holdings of these bonds started declining as households redeemed them. But an interesting shift appears to have occurred beginning in early 2025. Investors largely stopped reducing their holdings and instead began rolling them over at relatively stable levels.

That stabilization may be telling us something important. It suggests households still want some degree of inflation insurance even after inflation has come down considerably from its peak. Again, this could simply reflect the lingering psychological scars from the COVID inflation experience. But it may also signal a growing awareness that inflation risks remain elevated in an environment of large fiscal deficits, geopolitical uncertainty, and recurring supply shocks.

Either way, households appear more inflation conscious than they were before 2020. But household psychology alone cannot tell us whether the broader nominal economy has truly become unmoored. For that, we need to look at total dollar spending in the economy.

Cross Checking with NGDP Growth

The best test of whether the nominal economy remains anchored is not survey data, Google searches, Series I bonds, Treasury market signals, or temporary swings in inflation. It is, in my view, total dollar spending relative to a stable benchmark growth path.

As I have argued before, total dollar spending, as measured by nominal GDP, provides perhaps the cleanest summary measure of nominal stability in the economy. If the nominal anchor is truly slipping, it will show up in persistently excessive NGDP growth relative to its benchmark growth path.

In an earlier post, I showed that a benchmark path for nominal GDP can be created by summing the CBO’s potential real GDP growth rate plus 2 percent for targeted inflation. Using this benchmark, the figure below shows NGDP growth recently accelerating above its benchmark path, suggesting excess aggregate demand pressures are running the economy somewhat hot.

However, most consensus forecasts expect this overshoot to fade as seen in the figure too. In other words, forecasters generally believe NGDP growth will gradually return toward its stable benchmark path rather than continue drifting upward as it did during the 2021-2022 inflation surge.

That distinction is critical. Temporary overshoots can occur even in a well-anchored nominal regime. What matters is whether households, firms, and markets believe those overshoots are temporary or persistent.

The second chart below is even more revealing.

It shows two longer-term forecasts of NGDP growth: first, the expected average NGDP growth over the next five years, and second, the expected NGDP growth five years from now over the subsequent five-year period. That latter measure effectively asks whether the economy is expected to remain anchored well beyond the current business cycle.

And the answer from the data is remarkably reassuring.

Even as near-term NGDP growth expectations surged during the pandemic inflation episode, the five-year, five-year forward measure remained extraordinarily stable. In other words, even in the midst of the largest inflation surge in 40 years, forecasters largely believed policymakers would eventually return the economy to a stable NGDP growth path near 4 percent.

That is exactly what a credible nominal anchor should look like.

To be sure, the Fed’s credibility was tested during the pandemic inflation surge. And one can reasonably debate whether policymakers reacted too slowly in 2021. But the longer-term NGDP forecasts suggest that, despite these questions, the broader public still believes the Fed ultimately remains committed to preserving nominal stability.

Conclusion

The Federal Open Market Committee’s recent decision to adopt a wait-and-see posture on interest rates therefore appears reasonable. The economy still shows signs of elevated inflation sensitivity, and households clearly remain scarred by the inflation experience of the early 2020s. But the broader nominal anchor also still appears intact.

Most importantly, longer-term NGDP expectations remain remarkably stable. That stability suggests the public still believes the Fed will ultimately keep nominal growth under control over the medium to long run.

Still, Fed officials should not become complacent.

The stability of the five-year, five-year forward NGDP measure did not emerge automatically. It reflects years of hard-earned institutional credibility built up by the Federal Reserve. And while that credibility remains intact today, it can erode if policymakers appear inattentive to persistent inflation risks.

The lesson, then, is straightforward. The nominal anchor still holds. But the Fed needs to stay focused to keep it that way.

P.S. For more on NGDP as a cross-check at the business cycle frequency, see this recent coauthored paper of mine in the IJCB.

Before diving into these highlights, though , I would strongly encourage readers to check out Izabella’s Substack, The Peg. It’s one of the best sources out there on stablecoins, global payments, and the evolving financial architecture. I regularly read it. A must read for those following the digital payment space.

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Here are the key takeaways from our discussion:

• Not all “swap lines” are the same

  • There’s an important distinction between Fed currency swap lines and the Treasury’s Exchange Stabilization Fund (ESF).

  • Fed swap lines are standing arrangements between central banks to provide dollar liquidity, think ECB, BoJ, BoE.

  • The ESF, by contrast, is a Treasury tool with a long history (dating back to the 1930s) and more discretion, often used in targeted and sometimes controversial interventions (e.g., Argentina in 2025).

• Swap lines are less about usage, more about signaling

  • One of Izzy’s key points: these facilities often don’t need to be heavily used to matter.

  • Their mere existence reassures global dollar funding markets, similar to how deposit insurance stabilizes banking systems.

  • In that sense, swap lines act as a backstop for the eurodollar system.

• Why the UAE? Why now?

  • The UAE’s reported interest in a swap line comes amid regional stress (geopolitical tensions, weaker oil revenues, potential capital outflows).

  • Even countries with large sovereign wealth funds can face liquidity shortages. Assets are not the same as cash-on-hand.

  • A swap line would provide immediate, stigma-free dollar liquidity without forcing asset sales.

• This is as much about geopolitics as liquidity

  • The expansion of swap lines beyond traditional allies would mark a shift from purely crisis tools to instruments of strategic alignment.

  • There’s a plausible “quid pro quo” dynamic: access to dollar liquidity in exchange for geopolitical concessions.

  • The UAE’s position—potentially sitting between U.S. and Chinese financial spheres—makes it especially interesting.

• A quiet challenge to the IMF model

  • One of the more provocative ideas: swap lines could evolve into a bilateral alternative to the IMF.

  • Unlike IMF programs, swap lines can be faster, more targeted, and come with different (or less visible) conditionality.

  • In a more fragmented global order, this kind of parallel system could become more important.

• China’s swap lines are different

  • China has more swap lines numerically, but they are used far less for liquidity support.

  • Instead, they function more as tools of diplomacy and influence.

  • The key difference: the dollar system provides deep, liquid assets—China’s system still struggles on that front.

• Dollar dominance is not fading, it may be strengthening

  • Despite all the “de-dollarization” talk, the data point the other way.

  • Dollar usage in global payments is rising, and even Chinese institutions continue to accumulate dollar assets. See Brad Sester’s recent thread on China’s dollar holdings. And see the figure below.

  • The reason is straightforward: the dollar system still provides the safest, most liquid, and most credible financial infrastructure.

    

• Implications for the Fed’s balance sheet

  • Swap lines can expand the Fed’s balance sheet, but usually only temporarily.

  • Again, the signaling channel matters more than actual usage.

  • Still, this reinforces a key tension: you can’t fully shrink the Fed’s balance sheet while it serves as the world’s dollar liquidity provider.

• What to watch going forward

  • Any formal announcement of swap lines with non-traditional partners (like the UAE).

  • Signs of coordination—or tension—between the U.S. and China in third-party financial hubs.

  • Shifts in global financial centers (e.g., Gulf states vs. London).

  • Whether these arrangements migrate from the Fed to the Treasury (via the ESF), which would signal a more overtly political use of liquidity tools.

    Thanks for reading Macroeconomic Policy Nexus!

As most of you know, I host the weekly Macro Musings podcast. It began as a series of conversations about monetary and financial issues, but over time it has become a way to connect with a broader community of people who share a deep interest in these topics. What I’ve come to appreciate is that these conversations do not end when the recording stops. Instead, they often spill over into conferences, classrooms, and research, creating new connections and extending the life of the original discussion. In this edition of the newsletter, I highlight a few recent examples of the Macro Musings community in action.

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The Macro Musings Community: Wharton Edition

One of the great joys of my job is meeting listeners of the Macro Musings podcast. These encounters are often unplanned such as at conferences, when someone finds out I host the podcast and immediately lights up, eager to talk about a favorite guest or episode. A few times, people have even recognized my voice before anything else and asked if I host the show. I never get tired of these interactions. In fact, I’m still a bit amazed that part of my job is simply getting to connect with all these people.

I was reminded of this again recently at the 2026 Wharton Financial Regulation (FinReg) Conference, where I ran into many long-time listeners. I was pleasantly surprised by how many people in the financial regulation space follow the show. Peter Conti-Brown, the conference organizer, pointed out to me that the podcast has increasingly leaned into FinReg topics in recent years and, therefore, I should not be too surprised by the interest in the podcast coming from folks in FinReg.

Peter had organized a bike ride the day before the conference for early arrivals, and I was able to join. One of the riders was his colleague, Rory Van Loo, who mentioned that he had just assigned one of my podcast episodes to his class. He then invited me to stop by and chat with his students after the ride. I took him up on the offer, and it turned into a wonderful conversation covering a wide range of monetary and financial policy topics. Between the conference attendees and the students at Wharton, I was reminded just how fortunate I am to have a platform that connects me with so many curious and engaged people.

That sense of connection carried over into the conference itself. Peter had invited me to do a live taping of Macro Musings, and we decided to co-host it together (see the image above). It gave him a chance to turn the tables and press me on my own views, especially my growing interest in financial regulation. We also fielded some great questions from the audience. All told, it made for a fun and engaging conversation that will be released in a few weeks.

The conference also created opportunities for future episodes. I was able to line up two participants for upcoming interviews: David Zaring (Wharton), who was writing about “skinny” Fed master accounts long before they became a hot topic, and Stephan Luck (New York Fed), whose recent work sheds new light on what’s really is behind bank closures and what that means for policy.

The Macro Musings Community: Rich Clarida Edition

Another example of how Macro Musings has created unexpected and lasting connections are my ongoing interactions with Rich Clarida. He joins me on the podcast this week, and we cover a wide range of topics from the Fed’s soft landing to navigating supply shocks to rethinking the Fed’s balance sheet. But what makes this conversation especially meaningful to me is that Rich has been part of the Macro Musings story, in one way or another, almost from the very beginning.

That connection traces back to one of my earliest podcast guests, John Taylor, who set in motion a chain of events that led to a number of great interactions with Rich. Here is an excerpt from the podcast transcript where we discuss these interactions:

Beckworth: … we were talking before the show got started how you’ve actually been a part of this podcast, in some form, since its inception… I actually started the podcast back in 2016, so a decade ago… One of the first guests was John Taylor. I worked for him at the US Department of Treasury. Many years later, we start the podcast. He comes on. He had a great time. He had such a great time, Rich, that he invited me to present a paper at his Hoover Monetary Policy Conference back in 2016. I presented a paper. It was a co-authored paper. It’s an update paper of the Hélène Rey, the Pierre-Olivier Gourinchas paper that looked at the US as a hedge fund to the world or a banker to the world.

During the Q&A, you spoke up. You were one of the first people that spoke up. You said, “I commissioned that [Rey and Gorinchas] paper. I’m glad that you updated the data.” Then, that evening, we sat together at supper because they do arranged seating. They randomly do it, so they mix people up. Had a great conversation. I got to know you at Hoover via John Taylor because of the podcast.

Now, a few years later, it’s 2018, and we’re at a Cato Monetary Policy Conference. I see you, and you’re now the vice chair of the Fed. I’m thinking, “Man, I wonder if Rich remembers me.” You give your talk. I’m thinking, “What am I going to say to Rich? I got to go shake his hand. I’ve got to get his attention somehow.” Rich, you come up to me. You say, “David, you got a podcast.” You’d been listening to the show. Do you remember that?

Clarida: Yes. I do remember that. Not the exact quote, but I remember the conference and connecting there for sure.

Beckworth: Yes. Then, of course, you’re the vice chair of the Fed for a number of years. Finally, in ’24, we get you on the program. Had a great conversation about FAIT, about r-star, about inflation targeting, about your history. In fact, Rich, we talked a lot about your music career, and we did a bonus episode. Do you remember that?

Clarida: I do. Thank you for the plug.

That connection led to an opportunity that nicely illustrates how Macro Musings extends beyond the mic. While serving as Vice Chair of the Board of Governors, Rich graciously invited me to the Fed where we discussed NGDP targeting, drawing on a 2019 policy brief I had written. This took place during the Fed’s framework review and is a good example of how relationships formed through the podcast can lead to meaningful exchanges in real policy settings.

Connecting the Macro Musings Community Dots: Kris Mitchener on Ruth Judson on Fed Operating Losses

Two newer members of the Macro Musings community are Kris Mitchener and Ruth Judson. Both recently appeared on the podcast and from different but complementary angles touched on central bank operating losses. Taken together, their insights illustrate how separate conversations within the Macro Musings community can be connected to yield a richer understanding of an important policy issue.

Kris Mitchener, as you may recall, discussed his paper where he and his coauthors examine ten advanced economy central banks and ran a series of counterfactual exercises to see what really causes central bank operating losses. They found that operating losses are not an inevitable byproduct of disinflation efforts, but instead require the triple threat of (1) paying interest on reserves, (2) very large central bank balance sheets, and (3) a maturity mismatch created by holding long-duration, low-yield assets funded by short-term liabilities. Importantly, none of these factors alone is sufficient to generate losses.

The New York Fed’s 2025 annual SOMA report confirms this framework in real time. It finds that the large operating losses experienced in recent years have already begun to shrink because parts of the “triple threat” are starting to ease. In particular, lower policy rates and a sharp decline in interest-bearing liabilities like ON-RRP balances have reduced the Fed’s funding costs, while asset income has held up and is expected to rise as securities roll over into higher-yielding investments. As a result, the spread between asset returns and liability costs is improving and, according to the Fed’s deferred asset, the central bank is now generating modest net income.

My conversation with Ruth Judson adds another dimension to this turnaround in the Fed’s operating income. Her work on currency demand underscores the importance of the Fed’s currency franchise in supporting its bottom line. Jim Clouse, another Macro Musings guest, has similarly noted that currency is the Fed’s “golden goose”: it carries zero financing cost while funding investments in Treasury securities that yield a positive return. This combination materially boosts the Fed’s net income and helps offset the costs associated with interest-bearing liabilities. The Judson episode reinforced just how important this channel remains.

Historically, this currency franchise was the major funding source for most of Fed’s investments. But that ended with the advent of the ample-reserves system, which made bank deposits at the Fed and ON-RRP balances the dominant funding source for the Fed’s asset holdings. These liabilities funded a greater volume of interest earnings for the Fed, but also made the central bank more susceptible to interest rate risk as we have seen in the years 2023-2025.

The table below illustrates this development by breaking down the contribution to the Fed’s net interest income coming from its two main funding sources: currency and interest-earning liabilities (i.e. bank deposits and ON-RRP balances). These can be seen in the last two columns to the right:

The table indicates that the lower interest costs of the interest-earning liabilities in 2025 was the biggest improvement over the previous year though the currency franchise continued to provide meaningful support as well.

By way of comparison, below is the same table for the Federal Reserve Bank of Atlanta. It was the one Fed bank that kept generating net interest income over the entire 2023-2025 period:

So what explains the Atlanta Fed’s success during this time? The answer can be seen in the figure below. The Atlanta Fed simply funded with far more currency than the rest of the Federal Reserve System. In 2025, the currency-to-asset ratio in Atlanta was 78 percent compared to 33 percent for the rest of the Federal Reserve System.

What this comparison suggests is that we should expand Mitchener’s “triple threat” framework to include a fourth factor: the strength of the currency franchise. While his analysis rightly emphasizes the role of interest-bearing liabilities, balance sheet size, and maturity mismatch in generating operating losses, the composition of funding matters too. A central bank that relies more heavily on currency, a zero-cost liability, is naturally more insulated from the interest rate risk that drives those losses. Conversely, a weakening currency franchise removes this buffer. The Swedish central bank, the Riksbank, offers a cautionary tale, as its declining currency usage has contributed to downward pressure on its net interest income.

This, in turn, has an important policy implication. The Fed should guard the health of its currency franchise. While often taken for granted, robust demand for U.S. currency continues to play a quiet but important role in supporting the Fed’s balance sheet and operational flexibility. Preserving that franchise is not just a matter of convenience; it is a key part of maintaining resilience in the face of future monetary policy shocks.

Why These Conversations Matter

Stepping back, what I find most rewarding about these conversations is how they build on each other within the Macro Musings community. Kris Mitchener’s work helped me better understand the mechanics behind central bank operating losses, while Ruth Judson’s insights highlighted an often-overlooked margin, the currency franchise, that can materially shape those outcomes. Taken together, these perspectives deepen our understanding of recent Fed developments and show how ideas shared across this community can complement and enrich one another.

More broadly, this is what I mean by moving from conversations to community. The podcast is not just a collection of individual interviews; it is an ongoing dialogue where ideas extend beyond the mic, intersect across guests, and evolve over time. I am grateful to guests like Kris Mitchener, Ruth Judson, Rich Clarida, Peter Conti-Brown, Jim Clouse, and the broader Macro Musings community for making that process both possible and continually rewarding.

What do the Bank of England (BoE), the Reserve Bank of Australia (RBA), the European Central Bank (ECB), the Riksbank, the Reserve Bank of New Zealand, and the Bank of Canada all have in common today?

Over the past few years, these central banks have begun shifting toward demand-driven operating systems. Some, such as the RBA, ECB, and BoE, have conducted formal reviews of their frameworks, while others have moved more incrementally in the same direction. These operating systems rely more heavily on repo and lending operations as the primary elastic suppliers of liquidity and place greater weight on interbank lending to redistribute reserves across the banking system.

We have covered these developments both in this newsletter and on the podcast, including conversations with Isabel Schnabel about the ECB’s demand-driven ‘soft floor’ system, Laurie Bristow on the RBA’s demand-driven full allotment system, Bill Nelson on the BoE’s demand-driven repo system, and Per Åsberg Sommar on the Riksbank’s demand-driven, state-contingent operating system.

What unites these central banks is a growing recognition that interbank markets should play a larger role in reallocating liquidity, while central bank lending facilities should serve as elastic backstops that allow reserves to expand on demand rather than being pre-positioned in advance. In short, the global trend is away from balance sheet management and toward price-based, demand-driven liquidity provision.

The notable exception to this emerging consensus is the Federal Reserve. Its ample reserve system discourages interbank lending and relies on Reserve Management Purchases (RMPs) to grow reserves over time. While this approach may appear demand-driven too, it is fundamentally different. The Fed manages reserve quantities in advance through asset purchases, whereas its peers supply reserves elastically through routine repo and lending operations that respond to demand in real time.

But that may be changing. A number of recent official speeches suggest the Fed is poised to join the demand-driven central bank club. These remarks point to a potential break from the Fed’s long-standing commitment to its supply-driven ample reserve framework and toward a leaner, more demand-driven approach. The Overton window on the Fed’s operating system appears to be shifting. This is a huge change.

In the remainder of this newsletter, I will review the speeches that indicate there is a growing openness toward a more demand-driven operating system and then discuss why this change is warranted.

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A Growing Openness at the Fed

The speeches below reveal a marked shift over the past year in policymakers’ openness toward a more demand-driven operating system. There are likely other forces contributing to this change, but my focus here is on the visible change in how Fed officials are thinking about the Fed’s operating framework.

The first signs of a shift appeared in late summer 2025. In an August 25 speech, Dallas Fed President Lorie Logan reaffirmed her support for ample reserves but suggested, in the spirit of a demand-driven framework, that if the Fed wanted to minimize its financial footprint, it should do so by supplying reserves through "ceiling tools... and temporary operations" rather than maintaining large outright holdings. A month later, Fed Vice Chair for Supervision Michelle Bowman went further, expressing a preference for reserves “closer to scarce than ample” and arguing that lower reserve levels would improve market functioning and reduce the Fed’s footprint. Together, these remarks signaled that the Fed’s supply-driven ample-reserves framework was no longer beyond question.

The shift became more consequential on March 3, 2026. Governor Bowman directly challenged the post-2008 liquidity framework, arguing it may be encouraging liquidity hoarding and weakening the role of the Fed’s Discount Window (DW). At the same time, Treasury Secretary Scott Bessent and FDIC Chairman Travis Hill proposed allowing DW capacity to count toward liquidity requirements. While this idea had been raised before, the fact that three key policymakers advanced it simultaneously marked a turning point. Their speeches helped shift the focus from how the Fed supplies reserves to why banks demand so many of them. Regulatory policy and monetary policy implementation were now intersecting in public discourse in a way that pointed toward a more demand-driven system.

A more explicit shift emerged in late March and early April, as FOMC participants began outlining how to actually shrink the Fed’s balance sheet. In a March 26, 2026 speech, Governor Stephen Miran argued that a smaller balance sheet is both desirable and feasible, and that reducing banks’ demand for reserves is central to achieving it. He also released a coauthored paper, A User’s Guide to Reducing the Federal Reserve’s Balance Sheet, which provides a menu of policy options. Taken together, these reforms—many of which work by lowering reserve demand—could allow the Fed to shrink its balance sheet by roughly $1 to $2 trillion.

Then on April 2, President Lorie Logan delivered a speech and a coauthored paper with Sam Schulhofer-Wohl that also provided a menu of policy options for reducing the Fed’s balance sheet. They explicitly distinguished between returning to scarce reserves versus “shifting the demand curve inward” by reducing banks’ need for reserves. Their preferred approach is the latter option since it keeps the ample-reserves framework but makes it leaner and more demand-driven, one defined by spreads rather than the pre-positioning of large quantities of reserves.

Taken together, these developments suggest the Fed’s once sacrosanct, supply-driven ample-reserves system is likely to be replaced by a leaner, demand-driven operating system. It likely helps that the incoming Fed chair, Kevin Warsh, has also expressed support for rethinking the Fed’s balance sheet and operating framework. And, perhaps, the Macro Musings podcast’s relentless coverage of these issues and this newsletter has played some small role too.

To be clear, a shift to a more demand-driven operating system will take time and it will require the Fed to transform its ceiling facilities into business-as-usual sources of liquidity. But the path is now being set and the destination is becoming increasingly clear.

Why This Change is Warranted

So it appears the Fed may be moving toward a more demand-driven operating system. But is this shift warranted? While such a transition may make sense for other central banks, it is worth asking whether it also makes sense for the Federal Reserve.

In a recent Macro Musings podcast with Bill Nelson, we revisited the challenges of the Fed’s supply-driven ample-reserves system and the case for moving toward a more demand-driven approach. From that conversation, four key reasons emerge for why such a transition may be desirable: (1) a revival of interbank lending, (2) reduced liquidity fragility, (3) stronger bank lending to the real economy, and (4) greater central bank independence. Let’s consider each of these in turn.

(1) Revival of Interbank Lending

A central motivation behind the shift toward demand-driven systems abroad is the desire to revive interbank lending. In these frameworks, central banks want private money markets to play a larger role in allocating liquidity across banks, thereby enhancing price discovery and market discipline. By contrast, the Fed’s supply-driven ample-reserves system largely satiates banks’ demand for liquidity, leaving little need for an active interbank market.

This has important consequences. With abundant reserves readily available, banks have less incentive to borrow from or lend to one another. As a result, interbank activity atrophies over time. At the same time, limited use of private funding markets reduces banks’ use on the Fed’s ceiling facilities. This further reinforces banks’ preference to self-insure through large reserve holdings rather than engage in market-based liquidity management.

(2) Reduced Liquidity Fragility

Raghuram Rajan, in a series of papers with Viral V. Acharya, Rahul S. Chauhan, and Sascha Steffen, argues that the supply-driven ample-reserves system may itself be partly a byproduct of distortions created by QE that increase liquidity fragility.

They argue that as reserves flood into the banking system during QE, banks become more comfortable funding themselves with demandable deposits and other runnable liabilities while reducing more stable funding sources. The reserves created by QE are effectively treated as a backstop for these liabilities, leading banks to expand claims on liquidity even as reserves increase. As a result, the increase in reserves is offset by a corresponding increase in liquidity claims on banks, leaving net liquidity little changed.

Evidence from Rajan and his coauthors shows that these runnable liabilities rise during QE and do not unwind proportionately during QT. In other words, as reserves decline, these runnable liabilities remain causing net aggregate liquidity to shrink faster than headline reserve balances suggest. The result is a system that appears liquid on the surface but is more fragile in practice. This fragility helps explain why QT fails to fully offset QE and instead contributes to a ratchet effect on the size of the Fed’s balance sheet.

In this sense, the supply-driven ample-reserves system both reflects and reinforces a growing dependence on central bank liquidity. While it helps accommodate the higher demand for reserves created by QE-induced balance sheet distortions, it also entrenches that dependence by sustaining an environment of continuously ample reserves. A shift toward a leaner, demand-driven framework could help reduce this fragility by encouraging more active liquidity management and reducing reliance on persistently high reserve levels.

(3) Stronger Bank Lending to the Real Economy

Another concern with the ample reserve system, as shown by William Diamond, Zhengyang Jiang and Yiming Ma, is that large injections of reserves can crowd out lending by raising the marginal cost of expanding bank balance sheets. Thomas Hogan reports similar findings. These results are complemented by Raghuram Rajan et al.’s work on liquidity dependence, discussed above, which shows that QE-induced reserves are largely financed with runnable deposits and accompanied by a shift away from term funding toward short-term liabilities.

This shortening of bank liabilities makes banks more liquidity-sensitive and less willing to engage in maturity transformation, the very activity that underpins traditional bank lending. In effect, the asset-side intent of QE—to encourage longer-term lending—is partially offset by a liability-side response that pushes banks in the opposite direction. The result is a banking system that is less inclined to supply medium and longer-term loans.

(4) Greater Central Bank Independence

One of the key advantages of an ample-reserves system is that it gives the Fed two independent monetary policy levers: its policy rate and its balance sheet. That is, the Fed can adjust its target policy rate without having to change the size of its balance sheet. Alternatively, if the banking system is under stress and needs an injection of liquidity, the Fed can expand its balance sheet without altering its policy rate. Prior to 2008, this separation was not possible; the policy rate was tightly linked to the size of the balance sheet.

This feature of the ample-reserves system, however, is a double-edged sword. While it provides the Fed with greater flexibility, it also creates a temptation for Congress and other political actors to view the balance sheet as a policy tool for broader fiscal or credit allocation goals. If the size of the balance sheet does not affect the policy rate, why not use it to support student debt cancellation or finance other politically salient initiatives?

Moreover, the supply-driven ample-reserves system can create the misleading impression that the Fed is subsidizing banks and is subject to large operating losses, especially after encountering the zero lower bound. These perceptions invite political criticism and further undermine the Fed’s independence.

Conclusion

Taken together, these considerations suggest that the case for a more demand-driven operating system is not merely about aligning with global trends, but about addressing real shortcomings in the Fed’s current supply-driven ample reserve operating system. A leaner, demand-driven system would not eliminate all risks or tradeoffs, but it would move the Fed toward a more resilient, market-oriented, and politically sustainable operating regime.

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It is not easy being a central banker in a world plagued by supply shocks. These disturbances push economic activity and inflation in opposite directions, forcing difficult tradeoffs between full employment and price stability.

Fed officials now face such a challenge with the war in the Middle East. The resulting reduction in oil production could dampen economic activity while temporarily raising inflation. In this environment, it may be tempting to ease monetary policy to cushion the blow. But doing so would risk further stoking inflation. And if the public were already sensitive to inflation, such easing could unanchor expectations and make matters worse.

The conventional wisdom, therefore, is to “look through” supply shocks. Monetary policy cannot fix oil shortages, but it can worsen inflation. Better to stay out of the way and do no harm. Yet even this approach may prove insufficient. If households and firms are already on edge about inflation, even a temporary price spike could unmoor expectations. In that case, the Fed may be forced to tighten policy in an already weakened economy.

To avoid this latter outcome, it is important for central banks to have established inflation-fighting credibility in the first place. The Federal Reserve has such inflation-fighting credibility over the medium run according to inflation forecasts implied by the treasury market. But there are concerns that the spate of supply shocks over the past five years—the COVID pandemic, Russia-Ukraine war, trade war, Middle east war—plus the persistent above-target inflation over the same period might mean consumer inflation expectations are more fragile than what is seen in the treasury market. Both survey data and Google searches for inflation, as seen below, reveal this may be the case. Inflation continues to be an elevated concern for many Americans.

What More Can the Fed Do?

So what more can the Fed do to keep inflation expectations anchored while looking through supply shocks? Fed Chair Jerome Powell unwittingly hinted at an answer at the March FOMC press conference. It took place during an exchange between him and the Washington Post’s Andrew Ackerman (video of the exchange is above):

ANDREW ACKERMAN: “Thanks, chair Powell. The economy experienced a series of supply shocks, COVID, tariffs, two oil price shocks. Do you think that is bad luck or something has changed in the world that makes supply shocks more common and does the Central Bank need to take into account the supply shocks as a more common problem?”

JEROME POWELL: “We did go through a long period where the shocks were all demand shocks, and so we’ve had a lot of practice thinking about supply shocks in the last four or five years, for sure. It’s just a very different thing, and much more difficult thing, because it does immediately raise the question of tension between the two parts of our mandate. But, you know, has the world changed? COVID is a one-time thing, right? This energy supply shock is a one-time thing. It is not because of some broad tendency, I don’t think. The oil shock with Ukraine was a consequence of military action. I don’t know that the world changed that there will be more supply shocks but people have written that paper and that speech a number of times. People tried to make the case that is the case. In fact, we have seen more supply shocks in the last five years than we have seen in many years before that. It is a fact.”

Chair Powell makes two important points here. First, he is not convinced the world has fundamentally changed in a way that makes supply shocks more common, but still acknowledges the steady stream of supply shocks raises challenges for the Fed’s dual mandate. So the FOMC needs a robust way to handle them.

Second, even if supply disruptions have become more frequent, he does not see them as altering the underlying structure of the economy “because of some broad tendency.” His understanding is consistent with his colleagues on the FOMC as seen in the Summary of Economic Projections (SEP). FOMC participants continue to expect real GDP to grow around 2 percent over the long run. This forecast for relatively stable growth of potential real GDP plus the Fed’s 2 percent inflation target implies the FOMC is effectively aiming for approximately 4 percent NGDP growth.

These two observations—the FOMC needs a robust way to handle supply shocks and is implicitly targeting about 4 percent NGDP Growth—point to what more the Fed can do. If the FOMC were to (1) explicitly acknowledge this implied nominal anchor and (2) cross-check its actions against it, policymakers could more easily look through supply shocks while still keeping inflation expectations anchored. Under such an approach, it would not matter whether the world is prone to more supply shocks or not.

To be clear, nothing else needs to change. The FOMC keeps its current inflation-targeting framework, but simply acknowledges the implicit 4 percent NGDP target and then uses it as a cross-check on monetary policy.

Is It Really that Simple?

Yes. Here is an illustration of why this works. Consider a $30 trillion economy with an implied 4 percent NGDP target. Total dollar spending grows by 4 percent ($1.2 trillion), and the spending is evenly split, as intended, between higher prices and real economic growth. This first scenario can be seen in the table below under the “No Supply Shock” scenario.

Now imagine there is a negative supply shock. The economy still grows by $1.2 trillion, but now three-fourths of that spending ($0.90 trillion) goes to higher prices; only one-fourth ($0.30 trillion) goes to real economic growth. The FOMC does not need to know in real time how that nominal spending is split between inflation and real economic growth. Rather, it is content to see the dollar size of the economy anchored at 4 percent NGDP growth or $1.2 trillion.

Consider now a positive supply shock. The economy, again, grows by $1.2 trillion, but now three-fourths of that spending ($0.90 trillion) goes to real economic growth while one-fourth ($0.30 trillion) goes to higher prices. The FOMC again is content to see the nominal anchor of 4 percent NGDP hold.

Here is the key: FOMC members can look past short-run movements in inflation by cross-checking policy against the implicit 4 percent NGDP growth target. Put differently, when total dollar spending is on a stable 4 percent path, policymakers are automatically “looking through” supply shocks.

If these shocks are idiosyncratic and roughly symmetric over time—pushing inflation above target in some periods and below in others—then inflation will still average around 2 percent over the medium term.

So by cross-checking their decisions against the implicit 4 percent NGDP growth target, FOMC members can worry less about what is causing inflation in the short term and still feel confident they are anchoring inflation expectations over the medium run.

Cross Checking NGDP Growth In Practice

Okay, but how does the FOMC cross-check in practice? One simple way is to plot the actual NGDP growth rate against a benchmark NGDP growth rate. The figure below shows a benchmark measure—the blue line—created by taking the sum of the CBO’s potential real GDP growth rate plus 2 percent for the inflation target.

There is some art to interpreting this figure, but the key is that the FOMC should be trying to avoid NGDP growth run persistently above or below the benchmark. The two grey regions highlight an initial growth shortfall in 2020 followed by a period of makeup growth. These largely offset one another and are mostly a wash.

What matters more is what comes next: NGDP growth remains elevated above the benchmark for an extended period, albeit gradually declining, through 2024. NGDP growth briefly returned to the benchmark in the first half of 2025, but has since shown signs of reacceleration.

NGDP data are subject to revision, so the FOMC should also look to forecasts and high frequency data in cross-checking their decisions. The figure below shows the one-year ahead forecasted growth of NGDP from the Blue Chip consensus forecast along with the implied NGDP forecast using the CBO’s projection of the real potential GDP plus 2 percent for inflation.

An alternative way to visualize the forecast data is to look at the NGDP in level form. The figure below, using the same Blue Chip forecasts, reveals that by the second quarter of 2021 that the outlook was for an overheated economy in 2022 in terms of excess NGDP.

Finally, FOMC members can cross-check themselves with high frequency data like the monthly aggregate payroll index series (a proxy for aggregate labor income) or monthly nominal personal consumption expenditures. These series are narrower in scope, but are closely related to NGDP. Also, work by Skanda Amarnath, Carola Binder, and Lars Christensen show other ways to use real-time data in this context.

There are more sophisticated versions of this approach and I have written elsewhere about how the FOMC could more thoroughly incorporate some of these ideas. The more modest goal here, however, is simply to have the FOMC cross-check its decisions against basic NGDP measures.

It is worth nothing that cross-checking with NGDP is not a new idea. Former Fed Vice Chair Don Kohn, as a staff economist, used it during the 1990 energy shock. More recently, Vice Chair Rich Clarida also invoked NGDP as a useful gauge in assessing the economy. These examples suggest the approach is already familiar within the Fed. It just needs to be used in a more systematic manner.

Conclusion

Supply shocks are difficult, but they do not have to be destabilizing. By explicitly acknowledging and cross-checking against its implicit NGDP target, the FOMC can better distinguish between temporary and sustained inflation surges.

In doing so, it can more confidently look through supply shocks in the short run while keeping inflation expectations anchored over the medium run. That is a simple, practical improvement to monetary policy in an increasingly uncertain world.

Can overprotecting the financial system make it more fragile? There appears to be a growing consensus that the answer is yes when it comes to the post-2008 liquidity regulations. These rules were intended to make the banking system safer by ensuring that banks had enough liquidity to withstand funding stress without first turning to the Federal Reserve. In practice, however, these regulations have encouraged banks to excessively self-insure and treat their liquidity buffers as untouchable hard minimums. The result is a banking system characterized by liquidity hoarding, a hollowed-out interbank market, and a large structural demand for reserves. This outcome can exacerbate periods of liquidity stress.

Moreover, these same regulations have also reinforced the longstanding stigma surrounding the Federal Reserve’s Discount Window (DW). Because banks are expected to meet liquidity needs with their own balance sheets, turning to the Fed for liquidity can be interpreted as a sign of weakness. This regulatory framework, therefore, further discourages the use of the DW while encouraging liquidity hoarding. Overprotecting the financial system can make it more fragile.

Several key policymakers have acknowledged these challenges in recent weeks. In this newsletter, I will highlight their concerns, discuss their proposal of integrating the DW into liquidity regulations, add a few more DW reforms to the mix, and respond to the moral-hazard objection raised against reforming the DW.

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Policymakers Concerns and Solutions

The Board of Governors’ Vice Chair for Supervision, Michelle Bowman, gave a speech on March 3 that nicely motivates the issues at hand:

Fifteen years post-GFC, we need to know whether these [liquidity regulation] tools deliver the promised resilience or whether we have created a framework that looks impressive on paper but fails to capture the vulnerabilities that emerge in times of stress. It is time to move beyond asking whether banks are compliant and ask whether compliance actually translates into resilience.

Governor Bowman then notes that the liquidity regulations create two problems. The first problem occurs during normal times:

During normal times, banks over-allocate to HQLAs because they must demonstrate that liquidity needs can be met with their own balance sheet resources. At the same time, traditional Federal Reserve sources of liquidity—like daylight overdrafts, the discount window, and standing repo facilities—are stigmatized. This reduces a bank’s capacity to lend and support its communities.

The second problem appears during periods of stress:

During stress, the framework becomes pro-cyclical. Banks that maintain HQLAs at or above 100 percent of presumed outflows are often reluctant to use them out of concern they will fall below the minimum LCR. The LCR effectively becomes an isolated, unusable buffer. This reluctance exacerbates stress, forcing banks to convert less liquid assets into cash to meet obligations.

In short, the current liquidity framework may be making the banking system less resilient because it backfires in both good times and bad. It encourages banks to hoard liquid assets and avoid the Fed’s liquidity facilities in normal periods, while making liquidity buffers effectively unusable during stress because banks fear falling below regulatory minimums. In principle, the DW is supposed to serve as a liquidity buffer for the banking system, a backstop that banks can draw upon when funding pressures emerge. In practice, however, stigma has prevented it from playing that role.

Governor Bowman concludes by making the case that a modernization of the Federal Reserve’s DW so that it works with—rather than against—the current liquidity framework is a key step to solving these these challenges.

Treasury Secretary Scott Bessent and FDIC Chairman Travis Hill both pick up on this DW point in their recent speeches on liquidity regulation. Specifically, they argue that banks’ borrowing capacity at the DW should be recognized when assessing their liquidity positions.

Here is Secretary Bessent on March 3:

[T]he liquidity coverage ratio requirements [LCR] and other liquidity rules should give appropriate capped recognition of borrowing capacity associated with collateral prepositioned at the discount window.

And here is Chairman Hill on March 11:

[A]llow banks to recognize, up to a cap, their capacity to borrow from the Federal Reserve when calculating the LCR. This is a change the banking agencies could incorporate relatively quickly, yet thoughtfully, while still contemplating longer-term fixes to other aspects of the framework.

All three policymakers have more to say about Discount Window reform, but the central idea is clear: integrate the DW into the liquidity regulatory framework itself. Doing so would make the facility easier to use, reduce its stigma, and weaken the incentive for banks to hoard liquidity. Not only would this improve the DW’s functionality, but it would arguably lead to a more resilient banking system with less liquidity hoarding.

Do Banks Want Discount Window Reform?

Key policymakers seem eager to push Discount Window reform. But what about the banks themselves? Do they buy into the arguments outlined above? Fortunately, we do not have to speculate. Bill Nelson, Laurence Bristow, and Brett Waxman of the Bank Policy Institute recently surveyed their member banks to answer this very question.

The survey was conducted to determine what is driving the structural demand for reserves by banks and what could be done to reduce it. On the first point the authors note the following findings:

Survey respondents indicated that the main factors driving their demand were 1) internal risk management practices; 2) passing internal liquidity stress tests; 3) aversion to discount window borrowing and 4) the interest on reserve balances relative to rates on similar assets

These responses are revealing. They suggest that banks’ demand for reserves is not driven solely by market conditions but also by regulatory expectations and the continued stigma surrounding DW borrowing.

The survey then asked what changes would most effectively reduce banks’ demand for reserves. The authors summarize the responses as follows:

Treasurers stated that the three main changes that would be most effective at reducing their demand are: 1) allowing banks to anticipate borrowing from the discount window or Federal Home Loan Banks in their ILSTs; 2) counting discount window capacity toward the liquidity coverage ratio (LCR); 3) reducing discount window stigma.

Taken together, these responses align closely with the reforms discussed by policymakers above. Banks themselves appear to believe that better integrating the DW into the liquidity regulatory framework would lower the need for large reserve buffers (i.e. reduce liquidity hoarding). In short, this looks like a win-win for both policymakers and banks.

Beyond integrating the DW into liquidity regulations, there are other reforms that banks would likely support that could also reduce stigma and liquidity hoarding. First, the Fed could introduce a Committed Liquidity Facility (CLF), a pre-approved, collateralized credit line that banks pay a fee for and can draw upon as needed. This would give banks a dependable form of liquidity insurance that could also be recognized in liquidity regulations. Second, the Fed could revive a version of its Term Auction Facility (TAF), which would provide regular auctions of term credit to the banking system. Both reforms would help normalize use of the Fed’s DW. See Bill Nelson’s recent note for more details on these additional reforms.

Moral Hazard Concerns

Efforts to reduce Discount Window stigma and make it more accessible naturally raise concerns about moral hazard. As someone who generally prefers to see, on the margin, markets doing more and government less, I am often asked about this potential downside to DW reform. It is a fair concern.

Here are my two responses to this concern. First, as this FEDS Note shows, most advanced-economy central banks already operate what are effectively “business-as-usual” liquidity facilities that banks can access on demand against collateral. These facilities are routinely used to help banks manage day-to-day liquidity needs and to support monetary policy implementation. As the figure below illustrates, central banks such as the Bank of Canada, the ECB, the Bank of England, and the Riksbank all maintain standing liquidity facilities designed for routine use. In this international comparison, the Federal Reserve stands out as something of an anomaly. Its DW is rarely used in normal times because of stigma.

Importantly, there is little evidence from this cross-country comparison that the routine use of these business as usual facilities has produced debilitating moral hazard problems. Instead, central banks manage the tradeoff between stigma and moral hazard through facility design: adjusting pricing, collateral requirements, and disclosure practices.

Second, the tradeoff between stigma and moral hazard must be weighed against other risks created by the current liquidity regulatory framework. As the policymakers discussed above emphasize, the motivation for Discount Window reform is precisely that the existing system may be making the banking system more fragile through liquidity hoarding and entrenched DW stigma.

Moreover, the current framework creates a larger structural demand for reserves and, as a result, a larger footprint for the Federal Reserve in the financial system. This expanded footprint is reflected in the absence of a robust overnight interbank market and an unusually large Fed presence in repo and Treasury markets. The resulting large Fed balance sheet also invites political scrutiny and can undermine the Fed’s independence.

For all these reasons, an analysis of DW reform that focuses only on the stigma–moral hazard tradeoff is incomplete and potentially misleading.

The multiple tradeoffs discussed above are illustrated in the figure below. Observers who focus narrowly on the stigma–moral hazard tradeoff are effectively looking only at the right-hand side of the diagram, represented by the blue curve. Their concern is that making the DW easier to use could increase moral hazard by encouraging banks to take on more risk.

While that concern is legitimate, it overlooks the left-hand side of the figure. Stigma does not simply reduce moral hazard—it also encourages banks to self-insure by hoarding liquidity, represented by movement along the red curve. That behavior shows up in the form of large reserve balances, weakened interbank markets, and a larger Federal Reserve footprint in financial markets. In other words, reducing stigma may increase moral hazard, but it can also reduce liquidity hoarding and its associated distortions.

As depicted in the figure, the current U.S. system sits in a region where stigma is high and liquidity hoarding is substantial. A reformed system would move the operating point downward along the curves by reducing stigma and liquidity hoarding even if moral hazard rises modestly.

Conclusion

Policymakers are increasingly recognizing that the post-2008 liquidity framework may have overshot its original goal. By pushing banks to self-insure against liquidity stress while stigmatizing central bank borrowing, the current system encourages behavior that can make the financial system more fragile. Integrating the Discount Window into liquidity regulations and normalizing its use would not remove every risk, but it could restore the facility’s intended role as a liquidity buffer for the banking system. The challenge now is to design reforms that manage moral hazard while reducing stigma. If that balance can be struck, the result may be a more stable financial system with more buffer and less stigma.

This is a guest article by Peter Conti-Brown and is cross-posted on his Substack, PCB Central. We will host a Substack Live on Friday, March 6 at 4 p.m. ET to discuss the article. The video from that discussion will be posted below once it is recorded. — David Beckworth

The Federal Reserve has never had a year quite like 2025. It was, by my lights, the most challenging political environment for the Fed since its creation.

A potential exception is 1950 and into 1951. During that time, President Harry Truman—fighting for his political life amidst fears of war, hot and cold, and an economy that appeared to teeter on the brink of stagflation—made his relationship with the Fed a major focus of his attention.

The consequence of that focus was, by March 1951, the famous Fed-Treasury Accord (sometimes styled the Treasury-Fed Accord). This important moment in the Fed’s history has been the subject of great interest among historians and economists who study the relationship between the Fed and the rest of government.

And, perhaps unsurprisingly given the recent political focus, the Accord has come back to more general attention too.

The relationship between the Fed and Treasury, we are told, is not working. We need a new “Accord” to make it right.

I find the calls for a new Accord somewhat confusing and potentially confused. In today’s post I attempt to offer some clarification about what the Fed-Treasury status quo actually is and what a new Accord might mean.

The reality is that there is no such thing as a new Accord, in the singular.

There are Accords, plural.

Three, in fact.

In the first, we need to change the status quo so that the Treasury gets out of the business of setting monetary policy.

In the second, we need to change the status quo so that the Fed gets out of the business of interfering with politics outside of monetary policy.

In the third, we need to improve the collaboration between Treasury and Fed for better management of public debt markets to which both have important institutional roles.

Knowing which lane we are currently in will help us decide what kinds of course corrections are needed, if any are needed at all.

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Fed-Treasury Accord #1: Firing the Treasury from Monetary Policy

The most common conception of a new Accord is the transition away from Treasury dominance of the Fed.

The 1951 Fed-Treasury Accord is an example of precisely this dynamic. The 1935 Banking Act had formally liberated the Fed from under the Treasury’s thumb by removing the Treasury Secretary from the Fed’s Board and had created the modern office of Fed Chair, first occupied by New Dealer Marriner Eccles. But Eccles had worked so closely with the Roosevelt Administration that the Fed’s policies and the Treasury’s policies were indistinguishable. Certainly President Roosevelt viewed Eccles as a member of his Administration, something that Eccles did not dispute.

This subordination was all informal, though, a function of Eccles’s views on fiscal and monetary policy during depression that matched and even exceeded Roosevelt’s own views.

That level of informality changed with the Japanese attack on Pearl Harbor. Almost immediately thereafter, Eccles declared that the Fed would support the Treasury market by pegging short-term rates at 2.5%. That meant in practice that the Fed would make whatever purchases the government would require to maintain that level of interest.

There’s a name for this kind of commitment from a central bank to sustain government debt at fixed rates. It’s called “monetizing the public debt.” It’s a recipe for inflation.

The Fed—and Eccles—understood this dynamic with their eyes and mouths wide open. They warned about the consequences of such a prolonged policy and looked forward to the day when they would be liberated from that commitment.

Perhaps because of the agitation for that freedom, perhaps because Eccles had offended a prominent Democratic donor, Truman decided to demote him as Fed Chair in 1948. In a letter to Eccles, Truman explained that he was not going to reappoint Eccles to another term and offered him instead the Vice Chairmanship. Eccles called the bluff and accepted the slap-in-the-face demotion. Truman instead left the office vacant for the next several years.

Eccles then decided to do what no other Fed Chair has done since then: he stayed on the Board as Governor. During that time, he worked with others—in and out of the spotlight—to secure for the Fed the freedom to let interest rates rise or fall based on the value of the public debt, rather than supporting it through debt monetization.

Eventually, Eccles—and his successor, Thomas McCabe, alongside others like New York Fed President Allan Sproul—forced a weakened Truman to accept the Fed’s independence. To mark the occasion, the Treasury and Fed released a joint press release. It didn’t say very much, except to announce that an “accord” had been reached. In full, the Treasury and Fed announced:

The Treasury and the Federal Reserve System have reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government’s requirements and, at the same time, to minimize monetization of the public debt.

In practice, what followed thereafter was the notion that the Fed was free to set monetary policy—including rate targets—according to the needs of the macroeconomy as the Fed itself determined those needs to be. While not everyone at Treasury (and the White House) agreed that the 1951 agreement meant that Treasury no longer had a voice on monetary policy, in practice that institutional arrangement did indeed follow.

This first kind of Fed-Treasury Accord is the one that most people think of when the word “accord” is invoked.

But does it apply in 2026? Is the status quo Fed subordination, and a new Accord needed to remove that status quo?

No. At least, not entirely. President Trump has indeed altered the status quo by constantly seeking to undermine Fed policy and impinge on its legitimacy.

I would welcome a new Accord whereby the President and Treasury Secretary committed themselves to refraining from such commentary and pressure. I am not, however, holding my breath.

More to the point, I don’t think those calling for a new Accord are ready to admit that the responsibility for altering the status quo is entirely on President Trump. The only fix for this unhelpful alteration is to return to the before times when President and Treasury Secretaries didn’t resort to name calling, lawfare, and threats of criminal prosecution to get central bankers into line.

Fed-Treasury Accord #2: Removing the Fed from Politics

There is a conceivable second kind of Accord, although there is no record of it in history. In that scenario, the status quo of Fed independence is altered not by aggressive politicians at the White House or Treasury Department but from the Fed itself.

There are many examples of Fed chairs who have drifted inappropriately into politics. I mentioned one last week—Fed Chair Alan Greenspan’s aggressive advocacy for the privatization of social security. There are many others. The Fed’s principals are creatures of politics and sometimes do not exercise good discipline in staying in their own policy lanes.

A good recent example of such inappropriate political behavior is from Minneapolis Federal Reserve Bank President Neel Kashkari. Beginning in 2019, Kashkari put his name—and the Fed’s name—on an effort to amend the Minnesota constitution to require the state to “ensure quality public schools that fulfill [the] fundamental right” to a “quality public education … as measured against uniform achievement standards set forth by the state.”

The effort failed, ultimately. It did, however, result in a kind of Fed-Treasury Accord initiated unilaterally by the Fed: in 2022, the Board of Governors required the Banks to adopt a uniform code of conduct. Section 4.3 now requires the following:

An employee may not use, or create the appearance of using, their position or Bank resources to influence a partisan or non-partisan election or ballot initiative, such as a referendum or constitutional amendment.

It is appropriate to view this change, a direct reaction to Kashkari’s drift from the domain from central bankers to the domain of politicians, as a kind of Fed-Treasury Accord, a commitment by the Fed to prevent this kind of inappropriate public advocacy.

But does the Fed need to correct other forms of political drift? Some think so, but I don’t see it. The Fed’s research should remain wide open to the interests of its researchers. The Fed’s regulatory and supervisory work is necessarily political, not subject to these kinds of considerations, and importantly closely coordinated with the Treasury.

So much discussion, though, of a Fed that has lost its way appear to me a way to attempt to justify President Trump’s assault on the Fed on a better foundation than the one it is actually on: President Trump just wants lower rates and wants to do anything he can to get them.

Fed-Treasury Accord #3: Coordinating and Collaborating on the Management of the Public Debt

There is a third kind of Accord that would change the status quo by clarifying—perhaps altering—the roles that the Fed and Treasury play in managing their important institutional responsibilities relative to the public debt.

The original Fed-Treasury Accord of 1951 had an element of this. It was the second part of the deal that was reached, to “assure the successful financing of the Government’s requirements.”

This assurance does not violate any part of the Fed’s independence. It does not require the Fed to drift into political lanes. It is simply a commitment by the Fed and Treasury to work closely together to ensure that the changing nature of government financing does not turn into a fiscal or financial crisis.

I think of this kind of Accord as much less momentous and in some ways even more important than the other two.

It is much less momentous because this kind of collaboration is necessary and ongoing. We don’t need an Accord per se, but a commitment to revisit past assumptions when the tools of monetary policy or fiscal debt management start to lose their impact.

There are many proposals to revisit the assumptions about government funding and the Fed’s ample reserves framework in precisely this way. David Beckworth, for example, has advocated for a leaner Fed balance sheet that would require some coordination with Treasury to ensure its workability. Chris Hughes and Josh Younger have pointed to potential problems with the Fed’s ample reserves system relative to some politically sensitive issues. There are many such proposals, including in varying the kinds of government assets the Fed will hold on its balance sheet.

All of these are appropriate parts of the Fed’s and Treasury’s joint and separate responsibilities for “assur[ing] the successful financing of the Government’s requirements,” in the language of the original Accord.

This third kind of Accord is important, necessary, and vital to keep separate from the other two.

Risks of confusion

Why does any of this matter? Because if Important People go about Important Work of invoking Important History about Important Accords, we risk reforming institutions that do not need reform.

It also risks validating the very opposite of a Fed-Treasury Accord. The one Accord we do not need is the alteration of a working status quo in favor of a Fed that becomes more political, a White House that becomes more involved in monetary policy decisions, or a Fed and Treasury that become more dysfunctional in coordinating their responsibilities managing the public debt.

We are at an important inflection point in the Fed’s history, a time of greater political pressure than at any time in its history, including during the period of the World War II-era peg.

Where do we go from here? It is simple. Should Kevin Warsh proceed to confirmation hearings, he can and should commit himself to coordinating closely with Treasury on questions of mutual interest in managing the public debt without permitting the Treasury or White House to interfere with the day-to-day of monetary policy.

Secretary Bessent can and should commit the Treasury to ceasing the relentless criticism of Fed policy in favor of promoting a more seamless working relationship to tackle important questions involving the public debt maturity, the size of the Fed’s balance sheet, and its operating procedures as relevant to public debt management.

I suppose we can call it an Accord.

Well, imagine no more. Andrew Martinez, Alex Schibuola, and I have a forthcoming paper in the International Journal of Central Banking (IJCB) that looks at a novel measure of slack that outperforms traditional output gap measures on exactly these margins. It is revised far less in real time, improves inflation forecasts, and generates more stable Taylor rule prescriptions.

So what is this measure? It is the gap between the expected and the actual level of NGDP. Stated differently, it is the difference between the anticipated growth path of total dollar spending and its realized value. We call this the NGDP Expectations Gap, and in the paper we run it through a battery of real-time tests to demonstrate its reliability and usefulness for monetary policymakers.

One of the key reasons for its success is that it is model-free. It simply aggregates evolving professional forecasts, making it more robust to structural breaks and real-time mismeasurement than conventional gap estimates.

In this post, I want to delve deeper into its meaning and construction as well as provide the latest data. Before getting into it, here is a short clip from my podcast with Andrew Martinez where we discuss the history behind our collaboration.

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Theoretical Motivation for the NGDP Expectations Gap

As I have noted before, our economic lives unfold in nominal terms. In the United States, that means contracts, wages, debts, and payments are all denominated in dollars. While our ultimate concern is inflation-adjusted or real economic activity, the signals and constraints we face are expressed in nominal values. Consequently, when nominal rigidities exist—whether through sticky prices, wages, sticky debt obligations, or imperfect information—it becomes essential to keep total dollar spending on a stable growth path. Otherwise, shocks to total dollar activity will spill over into real economic outcomes and generate business cycles.

Moreover, because every dollar spent is a dollar earned, stabilizing total dollar spending is equivalent to stabilizing total dollar income. Consequently, a key condition for macroeconomic stability is maintaining a stable growth path for total dollar income.

Nominal GDP (NGDP) is a popular way to measure total dollar spending and nominal GDI (NGDI) is an equivalent measure for total dollar income. In theory, NGDP equals NGDI though in practice there are some measurement issues.

Our forthcoming paper in the IJCB draws from a measure I first developed in 2020 at the Mercatus Center. At the time, I called it the NGDP Gap. The idea is straightforward: it measures the difference between the actual and estimated benchmark path for NGDP.

The benchmark path for NGDP, which can be viewed as its neutral level, is estimated by taking the average of past forecasts of the NGDP level for a given quarter. Specifically, it takes the average of forecasts made over the previous 20 quarters for the current quarter’s NGDP level.

The logic behind this benchmark is simple. The neutral level of today’s total dollar spending (or total dollar income) should reflect what households, firms, and financial markets had been expecting as they made their economic plans over the past several years. When total dollar spending falls short of that expected path, macroeconomic conditions are tight and contractionary relative to expectations. When total dollar activity exceeds that benchmark path, macroeconomic conditions are expansionary.

Checking the Macroeconomic Pulse of the Economy

So what does the latest data show for the NGDP Gap? Using forecast data from the Survey of Professional Forecasters, the figure below shows the expected (i.e. neutral) path for the dollar size of the economy for both the 50th and 10th-90th percentiles versus the actual dollar size.

The figure shows the dollar size of the economic activity has been persistently higher than expectations since 2021Q4, though the difference is now is close to zero, at least for the upper bound of expectations. As of 2025Q4, the dollar size of U.S. economic activity hit $31.49 trillion, only $0.16 trillion higher than the expected 90th percentile forecast.

The figure below which shows the percent difference between the two series:

This measure indicates that macroeconomic policy, which reflects both monetary policy and fiscal policy, has been in an expansionary state since late 2021 but is now winding down and getting close to neutral.

Robustness of the NGDP Expectations Gap

Our forthcoming paper puts this measure to the test against conventional slack indicators, including the Federal Reserve staff’s output gap, the Congressional Budget Office’s output gap, and statistical approaches such as the modified Hamilton filter and the modified Beveridge–Nelson decomposition. We evaluate their performance along several dimensions: real-time revision properties, inflation forecasting accuracy, and the stability of implied Taylor rule prescriptions. Across these tests, the NGDP Expectations Gap performs as well as or better than the alternatives. It experiences substantially smaller revisions, improves post-pandemic inflation forecasts, and generates less volatile policy rule recommendations.

The paper also explains the rationale behind the five-year (20-quarter) window used to construct the benchmark path. The measure averages forecasts made over the previous 20 quarters for the same target quarter, which effectively centers the estimate around roughly 10 quarters ahead or 2½ years. That horizon is not arbitrary. It aligns closely with the business-cycle frequencies emphasized in the modified Hamilton filter and related forecast-based trend approaches, which find that medium-term horizons best separate cyclical movements from short-run noise. In short, the window is long enough to filter out transitory fluctuations, but short enough to remain responsive to business-cycle dynamics and evolving expectations.

In a previous post, I plotted the NGDP Gap against various measures of the business cycle: the CBO’s output gap, the San Francisco Fed’s cyclical core inflation, and the CBO’s cyclical unemployment. In each case, there was a strong relationship and the relationship was typically stronger using the 20-quarter horizon. The table below updates these relationships through 2025Q4 and confirms that the ongoing use of the longer forecast horizon for the NGDP Gap is appropriate.

Conclusion: Policy Implications

So what is the point of all this analysis? First, it shows that deviations from a neutral growth path of total dollar spending provide a robust signal of macroeconomic conditions. When total dollar spending falls short of this benchmark, conditions are tight. When it persistently exceeds that path, conditions are loose. For that reason, this measure could serve as a useful cross-check for the FOMC.

Second, it suggests that concerns about nominal GDP targeting being “too hard to measure in real time” are overstated. The NGDP Expectations Gap is not only measurable, it is more stable in real time than the conventional output gap measures policymakers routinely rely on.

I will end with the video clip below, also from my podcast with Andrew Martinez, which gives furhter details on the history of this measure:

This week the Macro Musings podcast went full video! Yes, after ten years and 530 episodes, we took the plunge and joined the world of full video podcasting. To be clear, our traditional audio version of the podcast will continue but now each episode will also be available in full video on YouTube. We’ve been slowly building toward this for some time, and it felt like the right moment to expand the show’s reach and give listeners a richer way to engage with our discussions. If you haven’t yet, I hope you’ll subscribe to the YouTube channel and help us grow this next chapter of Macro Musings.

To kick things off, we had Raghuram Rajan join us for a wide-ranging and timely conversation. Raghu is the former chief economist at the IMF, former governor of the Reserve Bank of India (RBI), and now a professor at the University of Chicago and chair of the Group of 30. Among other things, we discussed his famous 2005 Jackson Hole warning about financial fragility, his Volcker-like re-anchoring of Indian inflation, his efforts to stabilize India during the taper tantrum, and his views on the long-run prospects for the Indian economy.

Most of our time, though, was spent on his research addressing one of the most pressing questions facing the Federal Reserve: what are the long-run consequences of repeated rounds of quantitative easing? We explored his work on the “ratcheting effect” of QE, the growing liquidity dependence of the financial system, and why shrinking central bank balance sheets has proven so difficult in practice. I previously covered this research in an earlier newsletter and received several follow-up questions. In the remainder of this essay, I will summarize Raghu’s arguments, restate my proposed solution, and respond to a few questions.

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The QE Ratchet Effect and Liquidity Dependence

In a series of papers with Viral V. Acharya, Rahul S. Chauhan, and Sascha Steffen, Raghu shows that QE alters the liability structure of bank balance sheets. As reserves flood into the banking system, banks become more comfortable funding themselves with demandable deposits and other runnable liabilities while shrinking time deposits. The reserves created by QE are viewed as a backstop for these more liquid liabilities. The result is that even as QE raises the gross level of reserves, banks simultaneously expand claims on that liquidity. Net aggregate liquidity, therefore, is smaller than headline reserve figures suggest. When QT begins and reserves decline, those runnable liabilities do not unwind proportionately. This asymmetry—liabilities that expand during QE but do not contract during QT—is what Raghu and his coauthors call the ratcheting effect of QE.

The data strongly support this mechanism. Raghu’s work shows that demandable deposits rise during each QE episode and do not meaningfully reverse afterward. At the bank level, institutions that receive larger reserve inflows expand uninsured deposits and other runnable liabilities more aggressively. QE, in short, expands liquidity promises along with liquidity itself. When QT reduces reserves, those promises remain. Net aggregate liquidity therefore shrinks faster than headline reserve balances suggest.

Other research, such as Darst et al. (2026), reinforces this conclusion: QE may appear to flood the system with liquidity, but by reshaping funding structures and compressing private liquidity insurance, it can actually reduce effective liquidity in the economy. As a result, banks’ structural demand for reserves grows after each round of QE because the system itself has become more liquidity-dependent. In effect, the supply of reserves creates its own demand.

This dynamic looks less like a well-oiled liquidity machine and more like a liquidity blob. It grows larger, more complex, and increasingly dependent on continuous support.

If liquidity dependence is the problem, the solution lies in redesigning how liquidity is supplied, priced, and allowed to mature.

My Proposed Four-Step Solution

In the above Barron’s op-ed, I outlined a four-step approach to shrinking the Fed’s balance sheet. Those steps, however, can be understood more broadly as a blueprint for a state-contingent operating system, one that permits QE when needed at the ZLB while ensuring it is fully offset by QT once conditions normalize. Properly designed, such a framework would allow elasticity in bad times without embedding the ratchet effect into the Fed’s balance sheet.

The first step is to normalize the Fed’s ceiling facilities, the Discount Window and Standing Repo Operations. I outline some specific steps here that would reduce stigma and encourage routine use. Doing so would reduce structural demand for reserves.

The second step is to neutralize swings in the Treasury General Account (TGA), either by adopting Annette Vissing-Jorgensen plan or the Bill Nelson plan. The former relies on Treasury bill purchases and sales; the latter uses temporary repo operations to offset reserve fluctuations caused by TGA movements. Either approach would make it easier for the Fed to shrink reserves without jeopardizing interest-rate control.

The third step is a Treasury–Fed asset swap. The Treasury would issue additional short-term bills and exchange them for the longer-term bonds currently held by the Fed. Because these bills would not finance new spending, they would not count against the debt ceiling. Once the Fed holds short-term bills, it could sell them gradually or simply allow them to mature. In either case, the balance sheet would shrink more smoothly, and reserves would drain with less market disruption than if the Fed had to sell long-term bonds outright. Again, see this earlier newsletter for more details.

My fourth step directly addresses the Raghu ratchet effect. It calls for the Federal Reserve to adopt a corridor-style framework that would rely heavily on the term deposit facility. Specifically, the Fed would offer term deposits at the target policy rate, set interest on reserves slightly below it, and place the discount window and standing repo operation rates slightly above it.

By introducing maturity into the Fed’s liabilities, this structure would reduce banks’ reliance on runnable funding while preserving interest-rate control and lender-of-last-resort capacity. Because term deposits would earn more than overnight reserves, banks would have less incentive to treat reserves as a costless, open-ended backstop for short-term liabilities. Most importantly, term deposits would automatically roll off at maturity unless renewed. QT would therefore become the default once QE ended, preventing the supply of reserves from permanently ratcheting upward. This final step draws inspiration from the Riksbank operating system.

Questions on My Proposed Four-Step Solution

Below are three questions I have been asked multiple times about my proposal. My answers to these questions are provided below.

Question 1: You claim that when QE ends, term deposits would roll off unless renewed, and the balance sheet would shrink by default. Would not maturing term deposits just roll into regular reserve deposits?

Answer: First, note that under the current setup QT is initiated by the Fed in a top-down manner. Reserves fall exogenously and banks are forced to respond as best they can: hoard liquidity, cut credit, or bid up money-market rates. In short, banks adjust after reserves are removed, not before.

In my proposed setup, banks effectively initiate QT (after QE ends) on their own terms. That is, as term deposits mature, banks have to decide whether to (1) sit on the reserves they get once the term deposit matures (2) roll over the funds back into new term deposits, or (3) reduce their own balance sheets which, in turn, will allows the Fed to run off its asset holdings.

Option (1) is unlikely because, under this framework, reserves would earn less than the targeted policy rate, making them an unattractive asset to hold in large quantities. Option (2) is also unlikely to dominate because continuously rolling over term deposits preserves balance-sheet size and the associated regulatory, capital, and leverage costs, even after the demand for excess liquidity has faded.

As a result, once QE ends and the value of warehousing liquidity declines, banks will find it optimal to shrink their own balance sheets. When they do so, the demand for Fed liabilities falls, allowing the Fed to let its assets mature without reinvestment. QT, therefore, occurs automatically, not because the Fed drains reserves but because banks no longer wish to fund a large central bank balance sheet.

Question 2: Would not the Fed-Treasury asset swap force the Fed to recognize the mark-to-market loss on its bonds?

Answer: The asset swap would not create new losses for the Fed; it would simply make existing unrealized losses transparent. The swap effectively transfers duration risk from the Fed’s balance sheet to the Treasury’s. To the extent losses exist, they are already there. The swap merely makes them explicit and places them at Treasury.

Question 3: Would not the Fed-Treasury asset swap affect term premiums on treasury bonds?

Answer: There should be no direct effect on term premiums. The long-term bonds currently held by the Fed are already out of circulation. In the swap, the Fed transfers those bonds back to the Treasury, which effectively retires them and issues short-term bills in exchange. From the public’s perspective, the stock of long-term bonds in circulation does not change.

A secondary effect is possible. Once the Fed holds short-term bills, it may sell them into the market. That would shorten the duration of Treasury debt held by the public. If investors then rebalance toward longer-term bonds, term premiums could actually decline rather than rise.

Conclusion

QE may be necessary in crises, but without structural reform it leaves behind a larger, more liquidity-dependent system each time. The challenge is to preserve elasticity in bad times while making discipline the default in good ones. Raghu and his coauthors’ work shows just how consequential this design choice is.

In the midst of another crypto winter, one class of crypto asset has quietly maintained its value: stablecoins. As the chart above shows, dollar-backed stablecoins like USDC and Tether have largely held their peg near $1.00 even as other crypto assets — including Bitcoin — have fallen almost 50 percent.

Of course, stablecoins are designed to be stable. But they have not always lived up to that billing. As the chart reveals, there have been periods when stablecoins fell below par, reminding us that the $1 peg is not absolute. Even so, the fact that they have recently held their ground while other risk assets have sold off is notable. Stablecoins, at least for now, have behaved like money.

This was the starting point of my recent conversation with Dan Awrey on Macro Musings. He makes the case that we are now living through an historical unbundling of money and payments. For hundreds of years, banking brought money, payments, and credit together in one institutional setting. That bundling was the result of trial, error, crisis, and reform over a long time frame.

Technology, however, is now rapidly pulling payments away from banks. Venmo, PayPal, USDC, Tether, and other payment innovations have created faster and more programmable payment instruments, often outside the traditional banking system. The payments side is innovating quickly. The legal and institutional foundations that make money safe and able to maintain a fixed nominal value — resolution regimes, central bank access, and interoperable payment rails — are moving much more slowly. That gap is where the fragility lies.

Fortunately, Dan has carefully thought through these challenges and written a book that responds to them: Beyond Banks: Technology, Regulation, and the Future of Money In the remainder of this newsletter, I will outline his proposed solution, assess what the GENIUS Act did accomplish, and explain why the Fed’s proposed “skinny” master account, while important, falls short of his ideal. Before jumping in, here is a brief video clip of Dan outlining these challenges:

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An Incomplete Payment Revolution: Dan’s Ideal Approach versus the GENIUS Act

At its core, the problem Dan identifies is not that stablecoins are inherently volatile but that the institutional foundations supporting them are incomplete. Payments technology has advanced rapidly, while the legal and monetary infrastructure that makes money truly safe has lagged behind. This mismatch creates what Dan calls “Gresham’s New Law”: good payments drive out good money. Consumers gravitate toward faster, cheaper, more programmable payment instruments, even if those instruments sit outside the resolution regimes, central bank access, and interoperable payment structure that historically made bank deposits stable. Monetary activity, in other words, is slowly migrating outside the institutions built to keep it safe.

Some want to turn back the clock on these payment innovations, but the horse is already out of the barn. The important question, then, is how to update the monetary plumbing in order to allow these innovators to operate safely and efficiently. To that end, Dan offers a detailed blueprint in his book that comprises two main parts.

Make Nonbank Money Safe

The first part of his reform is making nonbank money safe. Dan would amend the Federal Reserve Act (FRA) to expand eligibility for Fed master accounts beyond traditional banks and create a new category of federally chartered “payment institutions.” These institutions would be licensed and supervised by the Fed. They would function as narrow payment entities — no maturity transformation, no lending of customer funds, no shadow banking activities, and no Discount Window access — with 100 percent reserves held at the Fed. In short, if you issue money, you do not get to use that money to take risks.

Making money safe also requires fixing what Dan calls the “bankruptcy problem.” As he noted on the podcast, money can only maintain a fixed nominal value if users can rely on immediate access to it even when the issuing firm fails. Traditional Chapter 7 or 11 bankruptcy would not provide that certainty. Accordingly, Dan’s proposal exempts payment entities from conventional bankruptcy, appoints the Fed as receiver, and requires customer funds to be returned within one business day.

Make Infrastructure Interoperable and Safe

The second part of Dan’s reform focuses on the payments side. Granting master account access is necessary, but it is not sufficient. Dan would require equal, non-discriminatory access to the Fed’s payment rails for these new “payment institutions” and impose open-access and interoperability requirements on core financial market infrastructure. The goal is to prevent incumbents from erecting technical or institutional barriers that fragment the payment system.

In Dan’s framework, preserving the singleness of money matters. Different forms of digital dollars should remain exchangeable at par and seamlessly transferable across networks. Without open access and interoperability, the system risks splintering into siloed platforms and eroding the unity that makes a dollar a dollar.

Dan’s Ideal versus the GENIUS Act

So how does the GENIUS Act compare to Dan’s ideal vision of reform laid out above? In the podcast he outlined three areas where it falls short.

First, bankruptcy remains a serious vulnerability. GENIUS improves creditor priority but leaves stablecoin issuers inside the traditional Chapter 7 and 11 framework. That means redemptions could still be frozen while courts sort out claims, and legal uncertainty could surround the treatment of reserve assets. As Dan argues, money must remain usable even when the issuing firm fails. Without a bespoke resolution regime, stablecoins remain exposed to the kind of delay and uncertainty that can trigger destabilizing runs.

Second, GENIUS largely sidesteps the infrastructure question. It focuses on reserve quality and disclosure but says little about open access or interoperability across payment networks. Nor does it reform payment system governance. For Dan, this omission matters: without open, interoperable infrastructure, digital dollars risk splintering into siloed platforms and weakening the singleness of money.

Third, GENIUS does not provide stablecoin issuers with direct access to Fed master accounts. As a result, issuers must continue to rely on commercial banks and intermediated Treasury markets to manage reserves and meet redemptions. In a stress scenario involving a major issuer like Tether or Circle, Dan suspects the Fed would likely intervene ex post — through Section 13(3) emergency lending or expanded repo facilities — not to bail out crypto per se, but to prevent disruption in Treasury markets or the broader dollar system.

A recent MIT Digital Currency Initiative paper, The Hidden Plumbing of Stablecoins, makes many of the same points and extends them further. While acknowledging that the GENIUS Act substantially strengthens reserve quality and disclosure, the authors argue that maintaining par depends not only on asset quality but on the functioning of Treasury and repo markets, dealer balance-sheet capacity, and the operational reliability of blockchain infrastructure. Even conservatively backed stablecoins, they show, can face stress when redemption surges collide with market bottlenecks or technical disruptions. In other words, GENIUS treats stability largely as a balance-sheet problem. The MIT analysis suggests it is also a market-structure and infrastructure problem.

Skinny Fed Master Accounts to the Rescue?

Given these limitations of the GENIUS Act, it is fortunate that the Fed has proposed a “skinny” Fed master accounts or what it more formally calls a Payment Account. This special purpose payment account (SPPA) would provide eligible institutions direct access to Federal Reserve payment services, but only in a tightly constrained, payments-only form.

Under the proposal, the SPPA would be used solely for clearing and settlement. It would not pay interest, offer discount window access, or permit intraday credit. Balances would be capped overnight at the lesser of $500 million or 10 percent of total assets.

Dan noted on the podcast that the proposal does not expand statutory eligibility; only institutions already legally eligible for Fed accounts under existing law could apply. However, Dan also noted that if he were at the Fed he would be advising stablecoins to get OCC trust charters, which would make them legally eligible under existing law.

And, as it turns out, this exactly what we have been seeing recently. There was a large increase in OCC trust charter application by blockchain-related fintech firms in 2025 after the passage of the GENIUS Act. This can be seen in the figure below (source). There is likely to many more applications in 2026.

To be clear, the SPPA is a far cry from Dan’s vision of his proposed “payment institution” getting Master Account access. Still, it is a step in the right direction, and the Board of Governors invited comments on its proposal. In my own submission, I focused on two main recommendations.

First, the Fed should not pay interest on payment account balances. Stablecoins are more likely to displace physical currency than traditional bank deposits. Because currency is a zero-interest liability that generates seigniorage revenue for the Fed, widespread adoption of dollar-based stablecoins could gradually erode that low-cost funding base. Keeping SPPA balances non-interest-bearing would help offset that displacement and preserve the Fed’s earnings capacity, an important safeguard for its operational independence.

Second, the overnight balance cap should not be fixed or arbitrary. Rather than imposing a blunt ceiling — such as the proposed $500 million or 10 percent of assets — the limit should be calibrated dynamically to stressed short-horizon liquidity needs and the structural displacement of physical currency. A properly designed balance cap would ensure continuity of payments during stress while allowing interest-free balances to scale with evolving payment demand.

Taken together, these recommendations place my approach somewhere between the Fed’s current proposal and Awrey’s ideal model. As the table below illustrates, Awrey’s framework calls for full Master Account access, strict structural constraints, and bespoke resolution — a clean narrow-payments tier anchored at the Fed. The Fed’s SPPA, by contrast, offers limited settlement access with tight caps and no statutory change. My proposal accepts the SPPA’s constrained structure but adjusts it to better reflect monetary realities: preserve seigniorage, allow balances to scale with payment demand, and ensure liquidity during stress.

Conclusion

Stablecoins may have held their peg through this crypto winter, but the real question is whether the system supporting them can hold through a financial storm. Payment innovation is not slowing down. The choice is whether to deliberately anchor it to the monetary system or wait until the next crisis forces our hand. As they say, the time to strengthen the plumbing is before the pipes burst.

Quantitative Easing (QE) is back in the news. So, too, is the large size of the Federal Reserve’s balance sheet. The public’s renewed interest in these topics has been sparked by President Trump’s nomination of Kevin Warsh to be the next Fed Chair. Warsh is a vocal critic of both QE and the Fed’s expansive balance sheet, and he has called for a “regime change” at the Fed on these issues.

I am broadly sympathetic to Warsh’s concerns about the size of the Fed’s balance sheet, and in previous newsletters I have outlined several steps to carefully reduce it. In this piece, however, I will focus on QE itself. That choice is motivated in part by my recent podcast conversations with Tyler Muir and Scott Sumner, where QE featured prominently. It is also motivated by a bit of serendipity: my wife recently unearthed the original version of the image shown above, which I first created back in 2014.

I sketched that image—originally in pencil and now enhanced with AI—during the debates over why QE1-QE3 failed to spur a more robust recovery from the 2007–2009 recession. Beyond its attempt at humor, the image captures a deeper puzzle: the stark divergence between the economic outcomes associated with QE during and after the Great Recession and those associated with the pandemic-era QE. What explains this difference?

To answer that question and address some of the concerns raised by Kevin Warsh, I will draw from my recent conversations with Tyler Muir and Scott Sumner. Specifically, I will outline three distinct views of QE that emerged in those discussions: irrelevance, insurance, and irreversibility. Before turning to them, though, it is helpful to first outline the conventional wisdom on QE.

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The Conventional Wisdom on QE

Large-scale asset purchases (LSAPs) by a central bank operating at the zero lower bound were first tried by the Bank of Japan (BoJ) from 2001–2006. The term Quantitative Easing (QE) was aptly applied to these LSAPs since the BoJ’s efforts were genuinely focused on expanding the quantity of the monetary base. The BoJ’s focus on the liability side of its balance sheet contrasted with the Fed’s focus on the asset side of its balance sheet during QE1-QE3. Former Fed Chair Ben Bernanke tried to highlight this distinction by calling the Fed’s LSAPs “credit easing” though this framing never stuck as he later acknowledged:

I also tried, without success, to name the program “credit easing,” to distinguish it from the Bank of Japan’s earlier foray into asset purchases (Bernanke, 2009). I argued that “credit easing” focused on removing duration from bond markets, in contrast to BOJ-style quantitative easing, which had the primary goal and metric of increasing the high powered money stock.

The distinction between asset-side QE and liability-side QE is more than a historical footnote. It reflects two different views of how central bank balance-sheet policies are supposed to work. After the Great Recession, the Fed’s asset-side framework became the conventional wisdon on QE, while the liability-side perspective was largely ignored. As I will argue in the section on irreversibility, this liability-side view can help explain why QE4 had a much larger macroeconomic impact than QE1–QE3.

Under the asset-side view of QE, LSAPs are supposed to operate primarily through two channels: the portfolio balance channel and the signaling channel. The portfolio balance channel works by reducing the supply of longer-duration or riskier assets held by the public, inducing investors to rebalance their portfolios toward close substitutes, which raises asset prices and lowers yields across markets. The signaling channel operates by reinforcing expectations that short-term interest rates will remain low for longer than previously anticipated, further easing financial conditions and stimulating spending.

Despite the conventional wisdom on QE, Ben Bernanke famously quipped in 2014 that “QE works in practice, but it doesn’t work in theory.” Although offered tongue-in-cheek, his remark captures a deeper tension: in standard benchmark models, LSAPs should have little to no effect on real economic outcomes. It is this theoretical challenge to the asset-side view of QE that motivates the next section.

The Irrelevance View of QE

The notion that QE should have no meaningful economic effect goes back to Neil Wallace’s 1981 paper, “A Modigliani–Miller Theorem for Open-Market Operations.” The basic idea is that, for a given fiscal policy, changes in the Fed’s balance sheet simply reshuffle government liabilities and do nothing to reduce aggregate risk in the economy. For example, suppose the Fed were to purchase risky corporate bonds from the public. It might be tempting to conclude that the private sector now bears less risk on its balance sheet. However, the Fed is part of the government, which in turn is backstopped by taxpayers. As a result, the private sector still ultimately bears the risk.

Michael Woodford and Gauti Eggertsson (2003) extend that logic further to show what they call the irrelevance proposition for QE: balance sheet expansions have no effect on real activity unless they credibly and persistently affect expectations about the future path of monetary policy. Absent such expected permanence, QE itself is irrelevant.

Taken together, the irrelevance view implies that the conventional asset-side channels of QE—portfolio balance effects and signaling—are largely illusory in benchmark models. Asset purchases merely reshuffle government liabilities without changing aggregate risk or real incentives. The same logic also applies to liability-side QE: expansions of the monetary base can matter only if they are expected to be permanent and greater than the economy’s real demand for base money. Absent those conditions, QE should have little macroeconomic effect.

But are these benchmark models the right lens through which to understand QE in practice? Tyler Muir, one of the leading experts on QE, says no. His views are considered next.

The Insurance View of QE

Tyler Muir noted on the podcast that the benchmark models underlying the irrelevance view abstract from the institutions that actually set asset prices. In practice, financial markets are not priced by a representative household, but by a relatively small set of financial intermediaries—banks, dealers, hedge funds, and other leveraged investors—whose balance sheets are limited and whose risk-bearing capacity varies over time.

In this setting, QE works by reallocating risk away from constrained financial intermediaries precisely when they are least able to bear it. When the Fed purchases long-duration or risky assets during periods of stress, it removes those assets from intermediary balance sheets, relaxes binding risk constraints, and compresses risk premia. Because intermediaries are the marginal price setters in bond markets, this redistribution of risk has large and immediate effects on asset prices, even if the associated fiscal risk is borne more diffusely and over time by households. QE really does matter!

Moreover, in a series of important papers, Muir and his coauthors show that QE1–QE3 cumulatively lowered the 10-year Treasury yield by roughly 115 basis points. Only about 40 basis points of this decline can be attributed to the direct, mechanical effect of the Fed’s asset purchases. The remaining 75 basis points reflects what Muir characterizes as a form of state-contingent insurance for bond markets (see his discussion of it in the video above). Because investors expect the Fed to intervene aggressively in adverse states, long-term bonds become safer ex ante, lowering yields even in normal times outside of crises. This insurance channel is large, persistent, and demonstrates that LSAPs operating through the asset side of the Fed’s balance sheet are economically meaningful.

Muir’s work should bring some solace to Ben Bernanke’s worries about the theoretical underpinnings of QE. Still, the question remains as to why the LSAPs of the pandemic period, often called QE4, seem to pack far much more of a macreoconomic punch than QE1-QE3. This question is taken up next.

The Irreversibility View of QE

One way to illustrate the different macroeconomic outcomes between QE1-QE3 and QE4 is to look at the level of aggregate demand they generated relative to an estimate of a neutral path. Fortunately, the Mercatus Center provides just such a benchmark in its NGDP Gap measure. Based on forecasts, this measure captures the level of nominal GDP—or, equivalently, total dollar income—that households and firms expected at a given point in time relative to what actually occurred. The expected path can be interpreted as a neutral benchmark for aggregate demand and is shown in the figure below.

The figure highlights a stark contrast between the two QE episodes. Following the collapse in aggregate demand during the Great Recession, NGDP never returned to its pre-crisis trend path. Instead, expectations gradually adjusted downward, converging only slowly to a new, lower level of NGDP. In sharp contrast, the 2020–2022 period saw aggregate demand not only return to its expected path, but overshoot it. Recall that NGDP is total dollar spending and over the medium run its level is a policy choice.

Now both periods had QE programs. So what explains the difference? One way to answer that question is to revisit the QE gallows humor image above: the Fed effectively shot the buffalo slug!

So what does “shooting the buffalo slug” mean? In my discussion with Scott Sumner, we emphasized that QE4 effectively demonstrated the power of level targeting. During the pandemic, the federal government was determined to restore the level of aggregate nominal income, not merely its growth rate. Massive fiscal transfers—accommodated and financed by QE4—that the public viewed as a permanent wealth transfer made that commitment credible. And, in fact, the level of nominal income was restored and then overshot.

Level targeting, however, carries an important implication: it requires a commitment to policy irreversibility. To restore a missed level path of nominal income, markets must expect that some portion of the Fed’s balance sheet expansion will not be undone. Put differently, for QE to meaningfully raise the price level and nominal income, it must be perceived as at least partially permanent.

This irreversibility view of QE brings us back to the earlier work of Woodford and Eggertsson (2003). They argued that expansions of the monetary base can matter only if they are expected to be both permanent and large relative to the economy’s real demand for base money. Under those conditions, inflation expectations rise, real interest rates fall below their equilibrium level, and aggregate demand accelerates. The same mechanism can be understood through a forward-looking quantity-theoretic lens: a monetary base expansion that is expected to persist will ultimately raise the price level and, with it, nominal income.*

At this point, it is important to note that from a consolidated government budget constraint perspective, a permanently higher monetary base must ultimately be validated by fiscal policy. If future fiscal policy is expected to fully reverse the expansion through higher taxes or spending cuts, QE will not be perceived as irreversible. Consequently, for the irreversibility channel of QE to operate, fiscal policy must be non-Ricardian. Such an arrangement, in economic substance, resembles an implicit helicopter drop.

To summarize, QE4 succeeded where QE1–QE3 struggled because it finally fired the buffalo slug: a credible, fiscally backed, and irreversible commitment to restore the level of nominal income, operating primarily through the liability side of the Fed’s balance sheet rather than through the specific assets it purchased.

Conclusion: What I Would Say to Kevin Warsh About QE

If I were to summarize the lessons from QE1–QE4 and address Kevin Warsh’s concerns I would say the following:

• QE should remain an important contingency tool, not a standing policy.
  QE has proven valuable in zero lower bound environments and during acute financial stress, but it is not something the Fed needs—or should want—to deploy under normal macroeconomic conditions.

• QE must be understood through both sides of the Fed’s balance sheet.
  Asset-side QE matters as Tyler Muir’s work shows. But the macroeconomic punch of QE4 came primarily through the liability side.

• The liability-side power of QE should be automated through a level target.
  The irreversibility channel works best when it is not discretionary. A clear NGDP levle target (my preference) or price-level target would create a systematic way to implement QE when needed without requiring ad hoc interventions.

• QE must be paired with a credible exit strategy.
  Precisely because QE can be powerful, it must be deployed in a way that allows for complete and orderly quantitative tightening once conditions normalize. I have laid out how to do this in previous newsletters.

Taken together, these points suggest that if QE is used sparingly, guided by clear rules, and paired with credible balance sheet normalization plans, it can remain a legitimate part of the Fed’s policy toolkit.

*It is worth noting that Woodford and Eggertsson (2003) were not the only ones making such arguments. Scott Sumner has written a nice paper on the Princeton School of Macroeconomics who made similar points. This group included Ben Bernanke, Gautti Eggertson, Paul Krugman, Lars Svennson, and Michael Woodford. In the QE gallows humor image up top, Paul Krugman is depicted with a t-shirt that refers to his seminal 1998 paper in this literature.

Kaleb Nygaard is back for the second part of his reporting on the changing nature of the Federal Reserve’s monetary policy decision-making body, the Federal Open Market Committee (FOMC). In the first installment, he documented when the FOMC met, how often it met, and how participation around the table expanded as staff involvement steadily grew. His work shows that many features of today’s FOMC that feel fixed and natural are, in fact, the product of gradual institutional change. His analysis suggests that the Committee will likely continue to evolve going forward.

In this second installment, Kaleb turns from who was in the room to who wasn’t, examining how vacancies and absences have shaped the FOMC’s functioning across its history.

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Meeting Attendance at the FOMC, Part II

By Kaleb Nygaard

In Part I in this series (linked here), I introduced a new qualitative data analyses based on attendance records in the minutes of every single FOMC meeting from March 18, 1936, to December 10, 2025. The full dataset is available in this spreadsheet. In today’s post I will show how vacancies and absences changed over time for both Governors and Reserve Bank presidents and end by highlighting one career staffer’s journey through the FOMC meetings over 20+ years.

In a previous data collection, I mapped out the family tree of every position on the FOMC. Below you can see each position’s attendance record. Two obvious findings here. First, (and we already knew this) but it’s interesting to see how much vacancy time the U.S. President and Senate have allowed for the Governors and how little time Reserve Banks go without a president. Second, Reserve Bank presidents have missed a lot of meetings. With the one major exception of the New York Fed President, who has been to more FOMC meetings than any other position on the committee except the seventh Governor seat, who have tied (down to the very meeting).

And if we switch from count to percentages, the numbers are even more readable. That first Governor seat has been vacant a solid fourth of the time since 1936. And although the Reserve Bank presidents have missed about the same number of meetings, they just stayed in their home town.

If you think this is all from the old days, you’d be correct for the absences, but not for the vacancies. We’ll get to that in a second. But first, I wanted to point out that the Boston Fed President literally didn’t attend a single FOMC meeting until 3.5 years after the committee began meeting. And the kicker is that this truant president was Roy A. Young, the former Governor (Chair before it was called that) of the Board in Washington. By the end of his time at Boston, Young had attended only 9 of 43 meetings, or 21%.

Now let’s see these attendance records over time. First up, here is a look at the data without separating by position. Here is the proof confirming your hunch that absences were a thing of the past.

And now let’s look at the data with the Governors and Reserve Bank presidents split out. It makes it very clear that most of the absences are from the Reserve Bank presidents and the vacancies are from the Governors. Though you can see the scandals (e.g. stock trading) that led to some vacancies in the 2010s and 2020s at the Reserve Banks.

The first meeting with the full 19 member FOMC was on September 28, 1950, fourteen and a half years after the first meeting. When you combine the truant Reserve Bank presidents and the vacant Governor seats, there really aren’t very many meetings with the committee at full 19 members. In fact, not a single year has had everyone present at every meeting.

For all meetings, only 17.5% have had the full committee present.

I’ve only done one sample analysis of the staff data, besides the aggregate counts. But here’s one final fun history you could do with the data: track a staffer’s history at the Fed. Here is my favorite former Board division director and current Yale professor, Bill English. First, a few headline stats and an image.

And here is his full history. You’ll notice that even though he was a division director, that isn’t listed here. This is an example of the weird governance overlaps of the various parts of the Fed system. During his time as Monetary Affairs Division Director at the Board of Governors he also served as Secretary of the FOMC. And since the FOMC and the Board of Governors are different entities within the Fed system, the Board position is listed only if the person doesn’t also hold a position within the FOMC itself. You can see a full list of all division directors, and the evolution of the directors themselves in a previous qualitative dataset of mine.

Another example of this, if you decide to peruse the meeting minutes yourself, you’ll see that the five voting Reserve Bank president member of the Committee are listed without titles, there are four Reserve Bank presidents that are listed as Alternate Members, and the remaining three are listed as simply presidents of their respective Reserve Banks.

There’s a lot to learn in the historical records of the Fed. Hope you’ve enjoyed this two-part chart journey through the attendance records of the FOMC as much as I enjoyed pulling out the data! Feel free to jump into it yourself and send me a note if you do anything interesting with it!

This week’s Supreme Court arguments over President Trump’s attempt to remove Fed Governor Lisa Cook have put an unusually bright spotlight on a question most people rarely stop to consider: what, exactly, is the Federal Reserve as an institution and how did its internal governance come to look the way it does? While the headlines focus on removal protections and presidential power, the deeper issue is the Fed’s evolving architecture: who sits at the table, who doesn’t, and how those patterns have changed over time.

Readers of this newsletter will recognize this theme from an earlier guest post by Kaleb Nygaard, where he dug up the largely forgotten history of how the Board of Governors has repeatedly redrawn the Fed’s district map under Section 2 of the Federal Reserve Act. This post continues that same institutional archaeology but turns inward, going from geography to governance.

In Part I of this new two-part series, Kaleb draws on a painstakingly assembled dataset from the minutes of every FOMC meeting since 1936 to document how the mechanics of monetary policymaking have evolved: when the Committee meets, how often, who attends, and how dramatically staff presence has expanded over time. The result is a set of striking charts that challenge the notion that today’s FOMC practices were fixed at the Fed’s founding. Part II, coming out early next week, will dig deeper into vacancies and absences at the FOMC. It also reveals how often seats on the Board of Governors and among Reserve Bank presidents have gone unfilled and what it meant for Fed decision making.

To cap it off, Kaleb and I will be hosting a Substack Live next week to discuss both articles and their implications. With that context in mind, here is Part I of Kaleb’s new series.

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Meeting Attendance at the FOMC: Part I

By Kaleb Nygaard

It’s easy to think that the rules were always so. That the routines were set in the founding days. The current state feels so natural. I’ve been an armchair Fed historian for more than a decade now and done dozens of these massive qualitative data analyses of old Fed documents. Yet each one surprises me with how much evolution it shows at the central bank. Below, I present the first in a two-part series with multiple charts that illustrate the evolution of the Federal Open Market Committee’s meetings.

This dataset is based on attendance records in the minutes of every single FOMC meeting from March 18, 1936, to December 10, 2025. The full dataset is available in this spreadsheet.

Executive sessions were recorded for the first twenty years, and as you can see in the first chart below, they represented approximately half of the total number of meetings held. Executive meetings refer to closed, internal sessions of the FOMC that were especially common in the Fed’s early decades. Attendance at these meetings was typically limited to the Board of Governors (or its predecessors), a small number of Reserve Bank presidents—often just New York—and a handful of senior staff such as the Secretary of the FOMC or the Manager of the System Open Market Account. Unlike regular policy meetings, executive sessions were used to handle sensitive administrative matters, operational details of open market operations, and other confidential issues, and therefore were recorded separately in the minutes. Most of the charts after this first one exclude the executive meetings because my primary focus on collecting this data was to chart attendance by the FOMC and Fed staffers from around the system.

Teleconferences began in the mid-1950s and were obviously the only way the committee met from February 2020 to November 2021. And for purposes of my dataset, I count a meeting as one day, hence the modern base count is 16, for the eight, two-day meetings, held approximately every six weeks these days.

Moving on to the next chart, we see that more meetings have been held on Tuesdays than every other day of the week combined.

Though it’s interesting to see a shift from Monday-Tuesday two-day meetings to the Tuesday-Wednesday sessions the Fed follows today.

One can’t have read Lords of Finance, or any Fed history book for that matter, and not have pondered the differences from today in what it meant “to work”. The head of the Bank of England or Federal Reserve Bank of New York taking off for months would be quite concerning today, but happened multiple times in the interwar period. And although I didn’t track sick-leave specifically, and Strong died before the FOMC was formally constituted, this example of meeting start-time left me with similar vibes. Average and modal start times for morning meetings (often the second day of meetings), shifted a full hour and a half from 10:30am to 9am.

Afternoon meetings, defined as starting after 12pm and historically the first day in two-day sessions, also became earlier. Though afternoon meetings aren’t nearly as common as morning meetings.

And now I’ll shift your attention from the “when” of the meetings to the “who”. This next chart might be my favorite one. It clearly shows the massive expansion of staff that is welcomed into the committee meetings, from a small handful for the first few years to approximately the same number as the FOMC through the 1950s. After that, the number of staff to FOMC double until around the turn of the century, when staff participation begins to grow, and grow, and grow. Last year’s average total meeting attendance surpassed 100 and the record attendance at an FOMC meeting was June 16-17, 2025 with 96 staffers.

I’m explicitly not going to comment on the pros and cons or optimal meeting size in today’s post, but the data in and of itself is fascinating.

Now let’s zoom in on the key players - the policymakers themselves. Amazing to think that something near full attendance wasn’t reached until the late-1950s. We’ll get into who was missing below.

But first, let’s compare the Chairs. Honestly, it’s impressive that a Fed Chair hasn’t missed a single FOMC meeting since Burns in the 1970s.

In Part II of this series, out early next week, I will show how vacancies and absences changed over time for both the Governors and the Reserve Bank Presidents. I’ll also show one example of what the data says about staff attendance.

The FOMC brought quantitative tightening (QT) to an end at its December 2025 meeting. In doing so, it reaffirmed something that has become increasingly clear over the past decade: the structural size of the Fed’s balance sheet keeps ratcheting higher after each round of QE. It all feels a bit like déjà vu.

As Bill Nelson noted, the Fed now believes it needs roughly $3 trillion in reserve balances to operate its floor system, implying a minimum securities portfolio of about $6½ trillion once currency in circulation and the Treasury General Account are taken into account. What stands out is not just the size of that number, but its direction. Over time, the Fed’s estimate of what constitutes “ample” reserves has moved in only one direction: up. The table below, drawn from Nelson’s analysis, reveals this pattern:

So why does reserve demand keep rising? Nelson’s explanation is that under an ample-reserves system, banks and supervisors adapt to whatever reserve level the Fed supplies—embedding those levels into stress tests and expectations—so reserve demand ratchets upward over time and is never revised back down.

A complementary explanation is that QE encourages the expansion of runnable liquidity claims, such as demandable deposits, thereby reducing net aggregate liquidity. This, in turn, makes QT increasingly difficult to implement without generating financial stress. In this newsletter, I explain this second mechanism as articulated by Viral V. Acharya, Rahul S. Chauhan, Raghuram Rajan, and Sascha Steffen in a series of papers. I then argue that the Fed can mitigate this challenge by using its term deposit facility in a manner similar to the approach now employed by the Swedish central bank, the Riksbank.

I learned of the Riksbank use of term deposits to manage liquidity and it potential application for the Fed in my recent conversation with Per Åsberg-Sommar on the Macro Musings podcast. That discussion was the genesis of the ideas developed in this newsletter. Be sure to check out the episode; a short video excerpt from the interview appears below.

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Ratcheting Up the Size of the Fed’s Balance Sheet through Liquidity Dependence

So why has QE proven so difficult to reverse? Acharya et al. offer a compelling answer: QE creates liquidity dependence.

Their argument begins with a simple but underappreciated observation: QE alters the liability structure of banks, not just mechanically but behaviorally. As QE expands reserve balances, banks grow increasingly confident that they can backstop withdrawals and drawdowns. This confidence, in turn, encourages banks to rely more heavily on relatively cheap, highly liquid funding sources—namely demandable deposits and credit lines.

Over time, this shift toward runnable liabilities creates what the authors call liquidity dependence. Driven by public demand for liquidity, institutional momentum in liquid liability creation, moral hazard arising from expected central bank intervention, and the structure of liquidity regulations, these liquid liabilities prove very difficult to unwind during QT.

The result is a fundamental asymmetry: QE expands banks’ liquid liability claims, while QT fails to reverse them—even as it reduces the reserves that backstop those claims. The system is thus left with a growing mismatch between liquidity promises and available liquidity, one that can ultimately be resolved only by renewed Fed balance-sheet expansion.

This is the ratchet mechanism at the heart of liquidity dependence. As the authors put it, “the supply of reserves creates its own demand for reserves over time, ratcheting up the required size of the Fed’s balance sheet” (p. 349).

The September 2019 repo market stress provides a concrete illustration. The standard narrative points to large inflows into the Treasury General Account (TGA) and reserve hoarding by a subset of banks. While not incorrect, Acharya et al. argue this explanation misses the deeper cause. Even as QT reduced the stock of reserves—the backstop for banks’ runnable liquidity claims—banks did not meaningfully shrink those claims. As a result, net aggregate liquidity was far smaller than headline reserve levels suggested. In that context, the TGA inflows were merely the final trigger, the “straw that broke the financial system’s liquidity back because the financial system was already overloaded with potential liquidity claims relative to available liquidity” (p. 414).

Acharya et al. argue that a similar dynamic also amplified the March 2020 “dash for cash.” After years of QE-driven expansion in runnable liquidity claims and a subsequent drawdown of reserves under QT, firms’ rapid credit-line drawdowns and investors’ scramble for cash exposed a system in which claims on liquidity far exceeded available backstops. In this sense, the pandemic shock laid bare the underlying liquidity dependence.

The liquidity dependence story be illustrated in the two figures below. The first one shows demandable deposits as a percent of total liabilities for private depository institutions with the time frames of the four QE programs shaded in grey.

The figure reveals that demandable deposits average between 40-50 percent of liabilities in the decades leading up to 2008. Since then, U.S. depository institutions have steadily shifted toward funding themselves more with demandable deposits, a trend that accelerates during QE episodes and in most cases does not reverse afterward. While post-crisis liquidity regulations such as the LCR shape banks’ asset holdings, they do not explain the persistent shift toward demandable funding shown here. Time deposits are treated more favorably than demandable deposits under the LCR, yet banks have continued to shorten liabilities during QE and failed to reverse this behavior during QT.

The rising level of demandable deposits occurs even as reserves as a percent of total bank assets temporarily declines as seen below:

In their latest paper, Acharya et al. show that this shift in funding structure is also highly uneven across the banking system, with liquidity risk becoming increasingly concentrated at small and mid-sized banks. Using bank-level data, they document that institutions less constrained by post-crisis liquidity regulations expanded uninsured demandable deposits and credit lines most aggressively during QE, while failing to unwind those claims during QT. As reserves drained from the system, liquidity tended to migrate toward the larger systemically important banks, leaving smaller ones with a growing mismatch between runnable liabilities and available liquidity.

The experience of Silicon Valley Bank illustrates this dynamic in an extreme form: although SVB’s failure also reflected idiosyncratic risk-management failures and an unusually concentrated depositor base, those weaknesses became fatal only once QT and rising rates exposed a broader reallocation of liquidity toward larger banks. In this sense, liquidity stress tends to surface first at the periphery—even when aggregate reserve measures still appear ample—ultimately forcing the Fed to respond at the system level.

If liquidity dependence is the problem, the fix must lie in changing how central bank liquidity is supplied.

A Cure for Liquidity Dependence: A Lesson from the Riksbank

Simply supplying ever-larger quantities of reserves cannot be that fix. It may relieve stress in the moment, but it also encourages banks to expand runnable liquidity claims that do not unwind symmetrically, leaving the financial system just as fragile—and often more so—when the next financial shock hits.

What is needed is a way to conduct QE that, first, does not incentivize the growth of runnable liquidity claims and, second, makes QT the natural, automatic default once large-scale asset purchases end. The solution, then, lies not in increasing the quantity of central bank liquidity, but in changing the form and pricing of Fed liabilities.

One promising approach, used by the Riksbank and discussed with Per Åsberg-Sommar on the podcast, is to make term deposits a core monetary policy instrument. The Riksbank operates a narrow corridor around its policy rate by offering banks a menu of standing facilities with different maturities and prices. Short-term central bank certificates (effectively term deposits) are offered at the targeted policy rate, while overnight deposits earn a rate set 10 basis points below the policy rate and overnight lending is available at a rate 10 basis points above it. This operating system can be seen in the figure below:

This approach creates a demand-driven operating system: banks themselves choose how much liquidity to hold as overnight reserves versus term deposits. Liquidity is always available—banks can sell certificates or borrow against them at a modest cost if reserves are needed—but they are simultaneously incentivized to minimize idle reserve holdings because term deposits earn more. In this way, the Riksbank can absorb excess liquidity during QE without creating fears of shortage, while maintaining tight control over short-term interest rates.

Ending Liquidity Dependence in the United States: Using and Properly Pricing the Term Deposit Facility

Imagine now that the Federal Reserve adopted a similar operating framework by offering term deposits at the targeted policy rate (i.e. federal fund rate) while setting interest on reserves 10 bps below it and and placing the discount window (DW) and standing repo operations (SRP) rates at 10 bps above the policy rate.

By introducing maturity into the Fed’s liabilities, this structure would reduce banks’ incentive to rely on runnable funding while preserving interest-rate control and lender-of-last-resort capacity. That is, since banks would earn a higher return by holding term deposits rather than overnight reserves, they would no longer treat reserves as a costless, open-ended backstop for short-term liabilities. This would dampen the incentive to expand highly liquid, demandable funding and instead encourage banks to rely more on term funding. At the same time, liquidity would remain readily available: banks could convert term deposits into reserves at a modest cost or borrow from the DW or SRP if needed, eliminating fears of sudden reserve shortages.

Just as importantly, this framework would make balance-sheet normalization much easier. As asset purchases ended, term deposits would mechanically roll off at maturity unless renewed, reducing central bank liabilities without discretionary action by the Fed. QT, in other words, would become the default outcome once QE ended, with liquidity contracting endogenously as banks adjusted their demand for term versus overnight central bank liabilities. In this way, the Fed could shrink its balance sheet without repeatedly triggering the liquidity stresses that have come to characterize recent episodes of QT.

Fortunately, the Federal Reserve already has much of this machinery in place. Since 2010, it has maintained a Term Deposit Facility (TDF) that allows banks to convert reserves into term deposits at the Fed. In practice, however, the facility has been rarely used and only on a limited scale. Recasting the TDF as a central instrument—priced at the target policy rate and embedded in a narrow corridor system—would fundamentally change its role. The TDF would become the primary way excess liquidity is absorbed and released over time. In this sense, ending liquidity dependence would not require inventing a new tool, but rather elevating an existing one to play the role it was always capable of playing.

Conclusion: From Liquidity Dependence to a Demand-Driven Fed

In an earlier newsletter, From Floors to Ceilings, I outlined three-steps needed to make quantitative tightening easier and more predictable. First, reduce duration mismatch through a Treasury–Fed asset swap. Second, neutralize volatility in the TGA so that fiscal cash management does not destabilize reserves. Third, normalize the use of ceiling facilities—the DW and SRP—to support a genuinely demand-driven system.

Taken together, these proposals point toward a state-contingent operating framework. In normal times, the system would function as a demand-driven corridor system in which banks are incentivized to move out of overnight reserves and into term deposits, while retaining the freedom to choose the maturity of their liquidity holdings. In periods of financial stress, the same framework would naturally shift into a ceiling system. When needed, it could also temporarily accommodate large-scale asset purchases and an ample-reserves configuration, without embedding those conditions as the permanent operating regime, because the pricing of term deposits would naturally pull the system back toward scarcity as conditions normalize. In this way, the Fed could preserve interest-rate control and financial stability without locking itself into ever-larger balance sheets.

In short, ending liquidity dependence does not require abandoning QE. It requires rethinking how central bank liquidity is supplied, priced, and allowed to mature over time so that discipline prevails in calm periods and elasticity is available when it is truly needed.

Update

In response to some questions asked about my term deposit idea for the Fed, here is an answer I wrote in another article that I am reposting here for convenience:

Question: You claim that when QE ends, term deposits would roll off unless renewed, and the balance sheet would shrink by default. Would not maturing term deposits just roll into regular reserve deposits?

Answer: First, note that under the current setup QT is initiated by the Fed in a top-down manner. Reserves fall exogenously and banks are forced to respond as best they can: hoard liquidity, cut credit, or bid up money-market rates. In short, banks adjust after reserves are removed, not before.

In my proposed setup, banks effectively initiate QT (after QE ends) on their own terms. That is, as term deposits mature, banks have to decide whether to (1) sit on the reserves they get once the term deposit matures (2) roll over the funds back into new term deposits, or (3) reduce their own balance sheets which, in turn, will allows the Fed to run off its asset holdings.

Option (1) is unlikely because, under this framework, reserves would earn less than the targeted policy rate, making them an unattractive asset to hold in large quantities. Option (2) is also unlikely to dominate because continuously rolling over term deposits preserves balance-sheet size and the associated regulatory, capital, and leverage costs, even after the demand for excess liquidity has faded.

As a result, once QE ends and the value of warehousing liquidity declines, banks will find it optimal to shrink their own balance sheets. When they do so, the demand for Fed liabilities falls, allowing the Fed to let its assets mature without reinvestment. QT, therefore, occurs automatically, not because the Fed drains reserves but because banks no longer wish to fund a large central bank balance sheet.

The FOMC’s decision to cut interest rates at its December meeting was not an easy one. Job growth has slowed and inflation remains elevated forcing the Fed to make a tough tradeoff as to which unwanted development is more important. The majority of the committee erred on the side of labor markets.

But not everyone. Fed Presidents Austan Goolsbee of the Chicago Fed and Jeffrey Schmid of the Kansas City Fed wanted to hold off on interest rate cuts until we got more information on the balance of risk. President Goolsbee later explained his decision:

Waiting to take this matter up in the new year would not have entailed much additional risk and would have come with the added benefit of updated economic data which have been absent lately. Given that inflation has been above our target for four and a half years, further progress on it has been stalled for several months, and almost all the businesspeople and consumers we have spoken to in the district lately identify prices as a main concern, I felt the more prudent course would have been to wait for more information.

I highlight this because President Goolsbee’s concern captures a deeper unease that now runs through monetary policy debates. The question facing the Fed is no longer just whether inflation will glide back to 2% with a bit more patience, but whether the economy has entered a world in which inflation is structurally harder to extinguish. December’s decision to cut rates despite stalled disinflation suggests that this possibility is no longer hypothetical—it is increasingly shaping policy choices in real time.

That broader concern is what motivated the Barron’s article below, which I wrote last month but feels even more relevant after the December FOMC meeting. The piece explores why inflation appears to have settled around 3%, why that outcome may be less about fading monetary resolve than binding fiscal constraints, and why the “last mile” back to 2% may be far more than a routine policy challenge. In short, it asks whether 3% inflation is becoming the de facto equilibrium of the U.S. macroeconomic regime.

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How 3% Inflation Became the New Normal*

The last mile of a long journey is often the hardest. The Federal Reserve has traveled far in its fight against inflation since it peaked near 9% in 2022. But since the summer of 2023, progress has stalled around 3%. The finish line—that elusive 2% target—remains just out of reach.

This two-year pause in disinflation, coupled with recent rate cuts and the prospect of more to come, has led some to wonder whether the Fed has lost the will to beat back inflation and has quietly resigned itself to a new normal, where 3% is the new 2%. It is more likely, however, that deeper fiscal forces are keeping inflation stubbornly elevated.

Fed officials insist they haven’t given up on their 2% target. Fed Chair Jerome Powell was emphatic about this at the Federal Open Market Committee press conference on Oct. 29. “We are absolutely committed to returning inflation to 2%,” he said. “There should be no question that that is where we are going.”

Economic data tell a different story. Headline inflation remains sticky near 3%, and forecasters expect that to persist. The Blue Chip consensus forecast expects personal consumption expenditure inflation—the Fed’s preferred measure—to hover near 3% through 2026. It won’t fall to 2.1% until 2030. The Philadelphia Fed’s Survey of Professional Forecasters shows even more drift: Both the 5-year and 10-year expected PCE inflation rates are edging higher, moving further away from the 2% anchor the Fed once took for granted.

These trends seem to suggest a softening of the Fed’s inflation target. Fed officials, however, are quick to note that part of the recent uptick in prices reflects the higher tariffs imposed by President Donald Trump. These tariffs, they argue, represent a negative supply shock—a drag on the economy’s productive capacity. In principle, such shocks shouldn’t lead to persistently higher inflation but rather a one-time adjustment in prices that temporarily pushes inflation above target. That is their hope, at least.

That hope isn’t much to hang on. Most supply shocks are, by definition, transitory and cannot explain the persistence of sticky inflation like the kind the U.S. has seen since mid-2023. The notion that a negative supply shock will have only a temporary effect on prices assumes that inflation expectations will remain well anchored.

Fed officials often cite bond market forecasts of inflation as evidence that inflation expectations remain well-anchored. But professional forecasters, as seen above, are beginning to mark up their inflation projections in this area, too.

Even more concerning, households appear to be responding as if the new tariffs will raise future inflation more persistently. Inflation from the Covid-19 pandemic left them scarred, more sensitive to price shocks, and less confident in the Fed’s ability to anchor inflation. Supply shocks, if anything, may now be making inflation stickier than fleeting.

This shift is reflected in the two figures below. The first figure shows one-year-ahead consumer inflation expectations across three major surveys. All three tell a similar story: expectations surge during the pandemic, then fall back, but settle at a level that so far appears structurally higher than before.

Survey responses can always be dismissed as cheap talk. To see whether this concern shows up in actual behavior, we can look at revealed preferences. Google searches for inflation also reveal a notable structural shift: people are now searching for the term at a consistently higher level than before the pandemic.

Fiscal Pressures and the Last Mile Back to 2%

If supply shocks and inflation psychology explain the current stickiness of prices, fiscal pressures explain why they may stay that way. The U.S. is entering a period where fiscal policy, not monetary resolve, increasingly determines the inflation path. With debt projected to climb well above 120% of gross domestic product under current law, and interest costs approaching $2 trillion by the early 2030s, the fiscal math is diminishing the Fed’s room to maneuver.

In such an environment, a 3% inflation rate is less a policy failure than an adaptation—the by-product of an economy adjusting to a chronic government deficit and the political impossibility of fiscal consolidation.

The early warning signs of fiscal dominance are already visible. Trump’s open calls for rate cuts on the grounds that they would “save $800 billion per year” are the clearest expression yet of monetary policy being viewed through a fiscal lens. Similar pressures appear in recent proposals by Republican senators to end interest on reserves as a way to save taxpayers money; in discussions to loosen the supplementary leverage ratio so banks can absorb more Treasuries; and in growing political enthusiasm for stablecoins, precisely because they create new captive demand for government debt.

Even the Treasury’s pivot toward heavier Treasury bill financing points to a world in which market structure, regulation, and innovation are quietly being marshaled to sustain an ever-larger debt load. These are the institutional tremors of a shift from monetary to fiscal dominance, small in isolation but revealing when considered cumulatively.

If this drift continues, the Fed may find that the last mile of disinflation is not just difficult, but unreachable. Once the consolidated government budget constraint begins to bind, the arithmetic of debt service, not the resolve of central bankers, will dictate the equilibrium inflation rate. Higher inflation becomes a feature, not a bug. It is a necessary lubricant for an over-leveraged fiscal state.

The Fed can talk tough, but as long as fiscal pressures dominate, its independence will remain conditional and its 2% goal aspirational. The last mile of disinflation may be the hardest, not because the Fed is weary, but because the road itself now bends toward fiscal dominance.

*The essay above is a slightly altered version of the original Barron’s article published on November 7. Specifically, a few paragraphs were added to allow for the Google Inflation search figure to be included in this essay and a new transition header was added for the fiscal pressures section.

President Trump will soon announce his pick for the next Federal Reserve Chair. Whoever takes the helm will inherit a full plate of challenges from Jerome Powell: interest-rate decisions, balance-sheet runoff, payment-system reform, regulatory overhaul, growing political pressures, and more. One thing the new chair will not inherit, however, is a Federal Reserve still incurring operating losses.

Yes, as our friend Bill Nelson first reported, the Fed is now generating net interest income for the first time since August 2022. Here is Bill:

Here is something to be thankful for this Thanksgiving: The Federal Reserve System has returned to profitability.  It appears to be on track for the combined profits of the 12 Fed banks to be over $2 billion in the current quarter… It lost about $240 billion to date.  These are real losses borne by taxpayers… If Atlanta and St. Louis continue to have profits of about $110 million per week, and the deferred asset continues to increase (become less negative) as it has done over the past two weeks…the Fed’s profits for the entire quarter will be $2.3 billion.

The primary reason for the recent losses is that the Fed’s interest expenses exceeded its interest income. This gap emerged because the Fed’s non-currency liabilities (bank deposits and ON-RRP balances) are extremely short-term and reprice almost immediately when interest rates rise, while its assets are longer-term, adjust more slowly, and were accumulated under QE during a period of very low rates. In effect, the Fed was carrying substantial interest-rate risk arising from a pronounced duration mismatch—a structure similar to that of many commercial banks—which left it vulnerable to rapid interest-rate hikes. And that is exactly what happened from 2022 to 2023.

Fortunately, the losses are ending, but as Bill notes, the Fed will continue to delay sending payments—“remittances”—to the U.S. Treasury for several years. Why does this happen and does it really matter? In this newsletter, I take up these questions by first examining the mechanics behind the Fed’s losses, both for the Federal Reserve System as a whole and for the exceptional case of the Federal Reserve Bank of Atlanta. I then show why the recent losses matter by exploring what the Fed’s time in the red implies for the future of its balance sheet.

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A Closer Look at the Fed’s Losses

As noted above, the Fed’s losses arose because interest expenses exceeded interest income following the sharp interest-rate hikes of 2022–2023. To avoid reporting negative equity, the Fed recorded its cumulative losses as a “deferred asset.” This item represents the amount of future profits the Fed must retain—rather than remit to the Treasury—until past losses are fully offset. In effect, the deferred asset acts as an accounting buffer that must be rebuilt before any payments can resume. As a result, the Fed’s remittances to the Treasury have been zero since September 2022 and, according to New York Fed projections, will remain so for several more years. That means larger budget deficits than would otherwise be the case.

The amount of this deferred asset can be seen by looking at the Fed’s H.4.1 series titled “Earnings Remittances Due to the U.S. Treasury.” The Fed explains this series as follows:

Positive amounts represent the estimated weekly remittances due to U.S. Treasury. Negative amounts represent the cumulative deferred asset position, which is incurred during a period when earnings are not sufficient to provide for the cost of operations, payment of dividends, and maintaining surplus. The deferred asset is the amount of net earnings that the Federal Reserve Banks need to realize before remittances to the U.S. Treasury resume.

Below is this measure. It shows that as of December 3, 2025, the Fed’s deferred asset is $243 billion.

The good news is that the Fed is generating net interest income again. This can be seen by taking the first difference of the deferred asset. It shows a positive value for the past few weeks, indicating the Fed is profitable now:

The Fed’s net interest income position has improved as interest expenses have declined with the reduction in short-term rates, while interest income has risen as higher-yielding securities have entered the portfolio through ongoing reinvestments. Together, these developments have narrowed the duration-mismatch gap and recently returned the Federal Reserve System to profitability.

Below is a table showing the Fed’s interest income, interest expense, and net interest income since 2008, the year the Fed effectively adopted an ample-reserves system. The last row shows the Fed’s financial position for the year through 2025Q3. This comes from the latest Fed financial statement and shows a stark improvement for the Fed’s bottom line.

Despite the losses of the past few years, it is worth noting that the ample-reserves framework generated roughly $1.2 trillion in net interest income through 2022. Some of these earnings covered operating expenses, but most of it was remitted to the federal government.

The final two columns above show the contributions to net interest income coming from the two major funding sources for the Fed: currency and interest-earning liabilities (i.e. bank deposits and ON-RRP balances). Historically, the Fed’s “currency franchise”—its ability to issue non-interest-bearing liabilities—has been its golden goose, providing an inexpensive and stable funding base for most of its operations. But that dynamic shifted with the advent of the ample-reserves system, which made bank deposits and ON-RRP balances the dominant source of funding for the Fed’s asset holdings. These liabilities funded greater interest earnings for the Fed, but also made the central bank more susceptible to interest rate risk as we have seen in the past few years.

The Amazing Federal Reserve Bank of Atlanta

Amidst a sea of red ink across the Federal Reserve System, one island of profitability remained above the waves: the Federal Reserve Bank of Atlanta. While every other Fed bank slipped into negative net interest income, Atlanta kept generating profits and, for most of the period, continued sending remittances to the Treasury. This can be seen in the table below, which reports the sources and contributions to net interest income for the Atlanta Fed:

What makes Atlanta’s performance so striking is how different its funding structure looked from the rest of the System. As the table shows, the Atlanta Fed continued to rely primarily on currency issuance—the Fed’s traditional, low-cost funding source—to support its asset holdings. While other Fed banks saw their balance sheets increasingly financed by bank deposits and ON-RRP balances, whose interest costs skyrocketed with the 2022–23 rate hikes, Atlanta held firmly to its currency base. This funding mix insulated the Bank from much of the duration mismatch that hammered the rest of the Fed, allowing it to remain consistently profitable even as its peers slid deep into negative net interest income.

I recently discussed this cash-driven funding advantage with Atlanta Fed President Raphael Bostic on my podcast, where he emphasized how the bank’s currency operations helped keep it in the black during the system-wide losses. He noted that demand for cash in Miami is particularly strong. This segment begins at 14:01 in the video below.

The importance of the Atlanta Fed’s cash operations can be seen in the figure below. It shows that the bank’s share of assets funded by currency not only remained the highest in the Federal Reserve System, but it stayed dramatically elevated throughout the ample-reserves era. While the rest of the Fed saw currency fall to a minority share of total funding, Atlanta’s ratio held firm, often exceeding 70 percent. This persistent reliance on the Fed’s “currency franchise” provided a remarkably stable buffer against rising interest expenses and, in effect, kept Atlanta financially afloat while the rest of the Fed was submerged by losses.

Why Does This Matter?

The Atlanta Fed may have avoided the interest-rate storm, but the rest of the Federal Reserve System did not—and the consequences of those losses reach far beyond reserve bank income statements. They spill into the federal budget, they expose structural vulnerabilities in the Fed’s balance sheet, and they point toward deeper challenges in a world where digital dollars are gaining momentum. This is why the question of “why this matters” is not merely academic. It bears directly on the Fed’s independence and the architecture of monetary policy in the years ahead.

The losses didn’t impair monetary policy, but they weren’t free.

Let’s start with the obvious: the Fed’s losses did not prevent it from tightening monetary policy in 2022–23 and keeping rates elevated through late 2024. As the past few years showed, the Fed can operate in the red and still raise interest rates aggressively when necessary. The mechanics of a central bank allow this.

But that does not mean the losses were costless. When the Fed’s interest expenses exceeded its income, remittances to the Treasury vanished and were replaced with a growing deferred asset—an accounting device that pushes losses into the future by withholding what otherwise would have been payments to the federal government. As Bill Nelson has emphasized, these losses effectively function as a tax because they reduce Treasury revenues and thereby widen the federal deficit borne by taxpayers.

It is true, as noted earlier, that the Fed has earned far more in cumulative profits during the QE era—roughly $1.2 trillion—than the $240 billion in losses suffered recently. But that is precisely what makes the transparency issue so important: the gains arrived as quiet windfalls, while the losses materialized in an obscure accounting construct that hides the timing and magnitude of the transfer. The asymmetry between visible losses and invisible gains amplifies misunderstanding and fuels political suspicion.

And losses inevitably invite political blowback. Calls to eliminate interest on reserves or otherwise reshape the Fed’s operating framework are already emerging. Without a more transparent accounting of gains and losses, the Fed risks having its independence eroded by misconceptions about what these transfers mean and whom they benefit.

The episode reveals deep structural vulnerabilities in the Fed’s balance sheet.

A second reason this experience matters is that it exposes the Fed’s balance sheet to recurrent interest-rate risk. As the recent losses made painfully clear, the Fed’s current operating framework all but guarantees periodic bouts of duration mismatch. QE will be used again the next time the zero lower bound is hit and when it is the Fed will once more accumulate long-duration assets funded by short-duration liabilities. QE1–QE3 were “lucky” in the sense that short-term rates stayed low for over a decade; but 2021–22 showed that luck is not a strategy.

In From Floors to Ceilings, I outlined a plan that, if applied systematically, would dramatically reduce the Fed’s exposure to the financial—and related political—risks created by these recurring interest-rate mismatches. Rather than relying on traditional QT, this approach consists of three steps:

1. Do a Treasury–Fed asset swap to reduce duration mismatch and enable a more orderly balance-sheet reduction.

2. Neutralize the TGA’s volatility, so fiscal cash management doesn’t destabilize the Fed’s liabilities.

3. Normalize the use of ceiling facilities—the Standing Repo Facility and the Discount Window—to support a demand-driven ceiling system.

This three-step framework would allow QE to be deployed when needed, but without leaving a noose around the Fed’s neck afterward. It would also make it far easier for the Fed to move between a crisis-time ample-reserves framework and a normal-time lean, demand-driven ceiling system.

Stablecoins shift the ground beneath the Fed’s balance sheet.

A third reason this entire episode matters—and one that reaches beyond the Fed’s recent losses—is that it highlights how the rise of dollar-based stablecoins could threaten the strongest and most stable component of the Fed’s balance sheet: its currency franchise.

As I discuss in Barbarians at the Fed’s Gate, widespread adoption of digital dollars could steadily displace physical currency. Physical currency provides the Fed with zero-cost funding; stablecoins do not. Jim Clouse estimates that under plausible scenarios, declining currency demand could reduce cumulative Fed income by $1.5 to $2.5 trillion over the next 30 years. That kind of erosion would fundamentally alter the economics of the Fed’s balance sheet. For example, imagine how much worse the recent Fed’s losses would have been had there been no currency funding.

The experience of Sweden’s Riksbank—which has already seen physical currency fall to minimal levels—is instructive here. It was forced to require banks to hold some of their deposits at the central bank in non-interest-bearing accounts in order to preserve the central bank’s financial independence. In other words, the Riksbank had to manufacture something like a new currency franchise once the old one evaporated. The Fed may face a similar dilemma if stablecoins take off.

One potential solution for the Fed on this front could come from the proposed “skinny master account,” which would allow eligible nonbank payment providers, including stablecoin custodians, to hold balances at the Fed that earn 0 percent interest. While not designed with seigniorage in mind, such accounts could serve as an accidental lifeline by giving the Fed a new pool of zero-cost funding in a world where digital dollars hollow out demand for physical currency.

Conclusion

In the end, the Fed’s losses are not the story, they are the signal. They reveal how the Fed’s operating framework, balance-sheet structure, and liability mix have become increasingly fragile in a world of higher rates and fast-moving digital finance. They expose hidden fiscal transfers, amplify political vulnerabilities, and highlight the need for a more transparent and more resilient approach to balance-sheet management. And as stablecoins begin reshaping the demand for Fed liabilities, the pressures will only intensify. If the Fed wants to preserve its independence and regain control over the size and risk profile of its balance sheet, it needs an operating framework built for the world we are entering, not the one we have left behind.