Federal Reserve Debates Balance Sheet Size

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The Federal Open Market Committee (FOMC) meetings last week received considerable media attention; after all, the Federal Reserve System is known as little more than the institution which raises interest rates every once in a while (or, once in eight years). The rate which the Fed raises is the target federal funds rate, or the rate at which the Fed aims to lend to other large commercial banks. A quick examination of the hawks and doves on the FOMC—those willing to raise the rates, ergo increase inflation at the cost of unemployment, and those who would not—revealed an obvious slant towards the latter; the outcome of the meeting was no surprise.


The media neglected to cover another, perhaps more crucial Fed event that occurred in Jackson Hole, Wyoming the week before school started. At that meeting, economists debated over the Fed’s longer-term policy framework including, importantly, the ideal size of the Fed’s balance sheet.


The Federal Reserve is, at its core, a system of banks. It possesses a balance sheet, or a sheet of assets and liabilities to which the bank is responsible. Before the Great Recession, the Fed’s balance sheet was $0.9 trillion; primarily, the Fed’s assets were Treasury securities and its liabilities were in Federal Reserve notes. During the crisis, the Fed’s balance sheet ballooned to $4.5 trillion, where it stands today. This increase in the Fed’s balance sheet is largely due to the Fed’s strategy of quantitative easing, by which the Fed, rather than use traditional monetary policy tools to stimulate the economy (such as decreasing the interest rate, which introduces the risk of deflation), instead injects money into the economy by purchasing assets from financial institutions, raising the prices of those assets. Of course, the Fed also bought US securities, in order to inject money into the economy through conventional means.


Alongside the increase in assets followed an increase in the Fed’s liabilities. The expansion of the money supply translates into increased liabilities in the form of Fed notes (currency). However, the largest expansion of the Fed’s liabilities came in the form of reserve balances, or, in other terms, money that commercial banks deposited at the Fed (which serves as the lender of last resort in the US economy). Like any bank, the Fed pays interest on money deposited; this interest rate is known as the interest on excess reserves, or IOER. The Fed also increased sharply its overnight reverse repurchase (RRP) program, or an agreement by which the Fed allows private-sector lenders to earn a fixed rate of interest on reserves held at the Fed for a short period. Between these two rates, the IOER (set at 0.5%) and the RRP (set at 0.25%) the Fed has synthesized a novel way of controlling the interest rates—the System assumes that private-sector banks will not want to borrow or lend at a rate much different from what the Fed offers; data collected over the past eight years seems to concur.        


That brings us to the meeting in Jackson

Federal Reserve Balance Sheet

Federal Reserve Balance Sheet

Hole. At the meeting, Chairperson of the Federal Reserve Janet Yellen announced a return to the pre-2008 balance sheet: to reduce the balance sheet from $4.5T to about $1.0T by naturally phasing out the RRP program, and to return to a method of influencing interest rates solely by manipulating the rate at which the Fed loans to commercial banks. The decision was contentious, with substantial arguments on both sides; former Chairman Ben Bernanke, for instance, felt convinced by those who argued to keep the larger balance sheet.


Those who argued to keep the large balance sheet cited the fact that a large number of relatively liquid assets could quickly placate a crisis, and that the private sector could not be counted on to provide that (they had not in 2008); they also argued that the informal relation between commercial banks and the Fed that the RRP promotes reduces stigma associated with borrowing the Fed’s money in times of crisis. Those who argued for a reduced balance sheet cited the fact that a large balance sheet and easy access to liquidity promotes risky behavior amongst banks, who have no incentive to prevent further financial collapses, as well as the fact that a Fed with massive asset holdings could produce financial losses; currently, the Fed turns a profit, which it uses to fund itself and the Treasury. Financial losses could inspire panic in the economy and, after Congress’s intervention, undermine the Fed’s independence and authority.

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