Monetary Policy Minutes: The Fed’s Balance Sheet

Photo of Economist Dave Wheelock | St. Louis Fed

The Federal Reserve’s balance sheet has more than quadrupled in size over the past 10 years, to $4.5 trillion. When the Fed decides to begin shrinking the balance sheet, what will that mean? Why is reducing it important? St. Louis Fed economist David Wheelock notes that the Fed’s plan is to reduce the size gradually. He likens this gradual process to stopping a car—letting off the gas and gradually braking would be less disruptive than slamming on the brakes. Listen to our 8 ½ minute podcast, released Sept. 1, 2017.

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Transcript:

Jennifer Beatty: Welcome to the Timely Topics podcast series sponsored by the St. Louis Fed. I’m Jennifer Beatty, your host for our segment, Monetary Policy Minutes. We sat down with an economist at the St. Louis Fed to up our game on the understanding of the Fed’s balance sheet and what may be coming just down the pike. Here’s what Dave Wheelock had to say.

Welcome, Dave.

David Wheelock: Good morning, Jenn. Good to be with you.

Jennifer Beatty: So I’m familiar with the concept of a balance sheet from a company perspective. Companies have assets and they have liabilities. But the Fed has a balance sheet, too. What comprises the Fed’s balance sheet in a nutshell?

David Wheelock: The Fed’s balance sheet, like any company, consists of assets and liabilities. And the Fed’s principal assets are the securities that it holds in its portfolio. And those securities consist largely of U.S. Treasury securities and mortgage-backed securities issued by Fannie Mae and Freddie Mac. The Fed’s principal liabilities are the reserve deposits that banks and other depository institutions hold with the Fed, as well as U.S. currency. Federal Reserve notes are a liability of the Federal Reserve banks.

Jennifer Beatty: Okay. So I hear in the news all the time this talk of the Fed wanting to shrink or unwind its balance sheet. What does that mean?

David Wheelock: Well, during and after the financial crisis, the Fed purchased large amounts of U.S. Treasury securities and mortgage-backed securities issued by Fannie and Freddie to provide liquidity to the financial system during the crisis, as well as to encourage recovery from the subsequent recession. These securities are, again, assets of the Federal Reserve banks, and the Fed paid for those purchases by adding to the reserve deposits banks and other depository institutions hold with the Fed, so again, the Fed’s liabilities.

Now that the economy is very close to the Fed’s goals of maximum employment and price stability, the Fed has begun to move forward with a—moving toward a more neutral policy stance. And, in part, that has involved raising the Fed’s target for the federal funds rate, which began about a year and a half ago. But it also could involve reducing the size of the Fed’s balance sheet. And the balance sheet size has been constant for some time now, but they’ve had the idea that, that once rates have gotten off that zero level they were for so long, that they would begin to reduce the size of the balance sheet.

Jennifer Beatty: So Dave, remind me again the size of the Fed’s balance sheet today, and then what—is there a target? What would be the ultimate size that the Fed would like to get to in its reduction?

David Wheelock: Ten years ago, before the financial crisis, the size of the balance sheet was about $925 billion. And it’s currently about $4.5 trillion. T—trillion with a T. A part of that simply reflects the fact that the currency in the hands of the public has grown over time. So the Fed accommodates the public’s demand for currency. We supply all they want, and that has essentially doubled in that 10-year period as well. So 10 years ago there was about $800 billion of U.S. currency in circulation, and now it’s about 1.6 trillion. So that alone accounts for an expansion of the balance sheet right there. So we’re never going to go back to 925 billion in terms of the Fed’s balance sheet, simply because the stock of currency has gone up so much.

Now, of course, much of the increase to 4.5 trillion was due to the purchases of the Treasury securities and the mortgage-backed securities. What’s going to be the ultimate long-run equilibrium size of the balance sheet, in part, depends on how the Fed intends to implement monetary policy going forward. 

Jennifer Beatty: So what would the mechanics be that the Fed would use to reduce the balance sheet then?

David Wheelock: They would do that by essentially not replacing securities in the portfolio that have matured. So as Treasury securities or mortgage-backed securities mature and are paid off by the government, the Fed has been going out in the market and replacing those securities with purchases of other securities so as to keep the balance sheet constant. And the idea of unwinding the balance sheet is simply stopping the replacement of securities that mature.

Now they have a plan for doing so that would be very gradual, so they would phase this in. So they would start by replacing a portion of the securities that mature, and that portion would gradually diminish over time, so you get to the point where they wouldn’t be replacing any securities that are maturing.

Jennifer Beatty: Okay. So you’re talking about the Fed simply allowing these instruments to mature, and then they wouldn’t reinvest. But would the Fed just outright sell the securities, like you could sell a stock?

David Wheelock: Well, the Fed certainly could sell securities.

Jennifer Beatty: Okay.

David Wheelock: But historically, it has generally not sold securities. And in terms of the plans that the FOMC has announced, they’re not involving outright sales of securities, but simply just not replacing ones that are maturing on the balance sheet. So as far as I know, there are no plans to sell securities any time soon. It’s certainly an option, though.

Jennifer Beatty: And so, why is it important to reduce the size of the balance sheet?

David Wheelock: Well, in a sense it—perhaps in an economically meaningful sense, the size of the balance sheet has been declining. Although the dollar amount is constant, the fact that the economy has been growing means that, as a percentage of U.S. GDP, the size of the balance sheet has been gradually being reduced because of the economy expanding. So in some sense, that may be the more economically meaningful concept anyway.

Of course, the absolute dollar value is what garners the attention and the focus, so the question is, maybe it’s time to pull back some of that very accommodative monetary policy that was put in place during the financial crisis and during the recession. As the economy has moved to maximum employment and price stability, it makes sense to sort of take your foot off the gas pedal a little bit and start to unwind some of that very aggressive accommodative monetary policy. And part of that would be to gradually ratchet down the size of the balance sheet.

It’s really akin to driving a car and as you’re approaching a stoplight, you take your foot off the gas and gradually brake rather than going 100 miles an hour right up to the stoplight and then slamming on the brakes. So it’s an idea of a gradual reduction is less disruptive than doing it all at once.

Jennifer Beatty: So by the Fed embarking on reducing the balance sheet, should the financial markets or should an investor take away, then, from this that the economy is moving in a positive direction, that it is expanding, and if the Fed’s reducing its balance sheet, it’s actually a good sign that the economy is growing?

David Wheelock: Right. The Fed tries very hard to be what we call “data dependent.” They respond to the way the economy is evolving and the forecasts for the economy going forward. And so if policymakers decide that it is appropriate to ease back on the gas a little bit, move toward a more neutral monetary policy stance, that could be taken as a positive sign in terms of, yes, we’re approaching our objectives, we have a healthy economy, and it’s appropriate to pull back a little bit on the very aggressive monetary policy that we had during the crisis and subsequently.

Jennifer Beatty: Great. All right. Well, thank you very much.

David Wheelock: Glad to be here.

Jennifer Beatty: For more information about the Fed or to listen to more of our podcasts, go to stlouisfed.org/timelytopics.