The Fed's balance sheet, past and future

THE LONG ROAD TO NORMAL

The Fed's balance sheet,
past and future

With inflation surging the U.S. Federal Reserve is tucking away the programs it used to support the economy during the pandemic, and that includes reducing the huge stockpile of government bonds and mortgage backed securities it has accumulated. Those assets were purchased to support financial markets and lending to businesses and households. The Fed does not think such support is needed anymore, and officials are debating how fast to pull back. Whatever they decide, businesses and households will feel it through higher borrowing costs and likely lower asset prices.

Averting a meltdown, part 1

When a deep financial crisis hit in 2007, the Fed quickly cut its short-term interest rate to zero -- and policymakers fast realized they needed to do much more to stop an economic and financial freefall.

Easing off the gas

The bondbuying went on longer than many officials expected as the Fed tried to nurse along a weak recovery. The Fed launched three separate bondbuying programs after the last recession. Some officials worried the central bank was forever distorting asset markets in the process.

Shrinking assets, but slowly

From 2013 to 2017 the Fed tiptoed towards a decision to shrink its asset holdings. Officials had no firm estimate about how large its balance sheet should be. The issue is related to changes in how the Fed manages the short term interest rate that it sets, and how commercial banks and other financial firms manage their own businesses. Policymakers had to feel their way to find what the proper level of system assets would be.

The pandemic explodes

The pandemic threw the Fed back in time, with financial markets again stressed, and policymakers again needing to offer the economy more support than could be provided by cutting the short-term policy rate to zero.

A pullback is coming, but how fast?

Just as Fed bond purchases help hold down borrowing costs, a smaller Fed balance sheet means less demand for various assets and higher interest rates. The Fed thinks that will help in the fight against inflation. Fed officials have already said they will let the balance sheet shrink faster than last time, when it was reduced by up to $50 billion monthly. Some officials say this time at least twice that amount should be siphoned away. It is still unclear, however, how big the balance sheet should be at the end of the process or how the economy will react along the way.

A faster runoff

Some Fed officials feel the large size of the balance sheet is unwarranted given the strength of the economy and high inflation, and have suggested reducing it by as much as $100 billion monthly. By some estimates that's the equivalent of increasing the policy interest rate by 0.6 percentage points a year, a little more than two standard rate hikes.

A more modest pace

In decreasing its balance sheet the Fed is also conscious of financial stability. A slower pace would give markets more time to adjust and mean less upward pressure on interest rates. It would also lower the risk of reducing the balance sheet by too much and leaving banks short of reserves.

Slow and steady

If the Fed went at the same pace as the last time it trimmed its balance sheet, progress would barely be noticeable given the large stock of assets the Fed has accumulated. A final decision has not been made but Fed chair Jerome Powell has said the reductions would likely be faster than before.

Editing by Sarah Slobin