The Fed has confirmed that it will stop slimming down its balance sheet later this year. Here’s what that means and why it matters.
Just like any company’s balance sheet, the Fed’s matches assets with liabilities.
After the financial crisis, the Fed cut interest rates to zero and began buying large amounts of Treasuries and mortgage-backed securities to help the economy recover from recession. These purchases created money in banks’ reserve accounts, money that the Fed hoped they would use to lend to consumers and to businesses.
This quantitative easing did help the economy recover, but it also swelled the Fed’s balance sheet to more than 4 trillion dollars—roughly five times the size it was a decade ago. As the economy grew healthier, the Fed began raising interest rates, and in 2018, it began gradually reducing its bond holdings. Some investors worried that balance sheet reduction would derail markets and tip the US economy into recession.
Now, in early 2019, the Fed has told markets [that] this process is almost complete—and that the balance sheet won’t shrink by nearly as much as it originally expanded.
Why not? Simple: it doesn’t need to.
As the Fed lets maturing bonds roll off the asset side of its ledger, there needs to be a corresponding decline in liabilities.
What are the Fed’s liabilities? The biggest one is currency. The Fed needs to hold an asset to match every dollar in circulation. And the demand for physical dollars around the world goes up every year, with no sign of slowing down. There is now almost $2 trillion circulating, so the Fed’s balance sheet can’t get smaller than that.
The Fed’s other major liability is excess bank reserves—funds that banks keep in their accounts at the Fed to manage their liquidity. The mechanism is complicated. But the Fed has now told us that it intends to leave more than $1 trillion in these accounts. That’s because the Fed’s benchmark rate has recently hovered near the top of its target range.
And if the Fed reduces reserves too quickly and by too much, it could lose control of that rate, which would hurt the economy.
Fed policymakers don’t want that to happen. And that’s why they have now indicated that the balance sheet will remain above three and a quarter trillion dollars—still roughly four times as large as it was before the crisis. Put another way: when it comes to the balance sheet, there’s a new—and bigger—normal.