How To Understand The Federal Reserve’s Balance Sheet

The U.S. Federal Reserve's balance sheet consists of the Fed's portfolio of U.S. Treasury and government-guaranteed mortgage-backed securities (MBS). Along with controlling short-term interest rates, the balance sheet is one of the Fed's main instruments for conducting monetary policy in order to execute its mandate of maintaining moderate interest rates and full employment.

Since the global financial crisis in 2008, and then again during the COVID-19 pandemic-induced economic lockdown in 2020, the balance sheet has taken on an outsized role—both literally and figuratively—in Fed policy and the U.S. economy and financial markets.

During these two crises, the Fed lowered short-term interest rates to zero but failed to stimulate the economy. The Fed then turned to massive increases in its balance sheet by buying up trillions of dollars of securities (government and mortgage backed) in order to try to lower long-term interest rates and stimulate economic growth. This process is called quantitative easing.[1]

Prior to the financial crisis, the Fed's balance sheet stood at about US$900 billion. In the fall of 2008, however, the balance sheet more than doubled in a matter of a few months to more than US$2 trillion by the end of the year.[2]

Through 2015, the Fed's portfolio rose steadily to about US$4.4 trillion, where it stood for the next four years or so as the Fed tried to stimulate a lackluster economy still bearing the effects of the crisis. Then, in early 2020, as the world economy largely shut down due to the pandemic, the Fed sharply increased its bond buying even further. It increased the balance sheet to more than US$8.9 trillion by the end of 2021, where it remains as of July 2022.[2]

What Is The Fed's Balance Sheet?

The Fed's balance sheet is made up of assets balanced by liabilities.

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What Are The Assets?

On the asset side, it consists mostly of fixed-income securities, namely U.S. government debt issued by the Treasury, and government-insured mortgage-backed securities issued by government mortgage agencies.

As of July 2022, the Fed's balance sheet totaled US$8.9 trillion, of which US$8.462 trillion (about 95%) was securities. Of that figure, US$5.733 trillion was U.S. Treasury securities and US$2.726 trillion was MBS.[3]

What Are The Liabilities?

The Fed's liabilities consist mainly of all U.S. currency in circulation held outside the Fed itself, bank reserves held in accounts at the Fed and its 12 regional banks, and reverse repurchase agreements collateralised by Treasury securities.[1]

In a reverse repo, the Fed sells a security and agrees to buy it back later, in effect draining reserves from the system; repos do the opposite, with the Fed adding reserves. Repos and reverse repos are two of the tools the Fed uses to add or drain temporary reserves from the financial system.[1]

The Fed publishes its balance sheet, called the H.4.1 report, every Thursday afternoon.[4]

Why Is The Fed Balance Sheet Important?

Investors, economists and others keep a close eye on the Fed's balance sheet. By expanding its balance sheet—i.e., by buying government bonds and MBS—the Fed expands the nation's money supply in the hope of lowering interest rates and stimulating the economy; contracting the balance sheet should have the opposite effect. However, by expanding the money supply too much, the Fed runs the risk of igniting inflation, while overly contracting it may stifle economic activity, including increasing unemployment.[1]

Reducing The Size Of The Fed's Balance Sheet

As noted, the Fed's balance sheet has been growing dramatically and nearly nonstop since the 2008 financial crisis. However, as the U.S. inflation rate soared to more than 9% annually in the wake of the post-pandemic recovery and more than a dozen years of Fed monetary and government fiscal stimulus, the Fed began to reverse course. It tightened monetary policy by raising interest rates beginning in 2022 and then planning to reduce the size of its balance sheet.[5]

On 4 May 2022 the Fed announced plans to begin the latter process by not reinvesting the interest and principal proceeds of its Treasury bond and MBS holdings as they mature and instead letting them run off.[5]

Beginning 1 June 200, the Fed said it would let US$30 billion a month of Treasury securities run off for three months, after which it would allow US$60 billion a month to run off. At the same time, the Fed would let US$17.5 billion of MBS run off each month for three months, after which the amount would increase to US$35 billion a month.[5] At that rate the Fed's balance sheet would be reduced by about US$3 trillion over the next three years.[6]

As of July 2022, The Fed has yet to announce plans to sell any of its bond or MBS holdings in the open market.

Summary

The U.S. Federal Reserve's balance sheet consists of its portfolio of U.S. government bonds and government-guaranteed mortgage-backed securities. In conjunction with its short-term interest rate policy, the Fed buys and sells securities from that portfolio to increase or decrease the money supply to try to influence long-term rates in order to achieve its monetary policy objectives. In 2022, following more than a dozen years of monetary policy stimulus, during which time the balance sheet grew from less than US$1 trillion to nearly US$9 trillion, the Fed began to decrease the size of its portfolio in the face of the highest inflation rates in decades.

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References

1

Retrieved 02 Aug 2022 https://corporatefinanceinstitute.com/resources/knowledge/finance/fed-balance-sheet/

2

Retrieved 02 Aug 2022 https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

3

Retrieved 02 Aug 2022 https://fred.stlouisfed.org/release/tables

4

Retrieved 02 Aug 2022 https://www.federalreserve.gov/releases/h41/

5

Retrieved 02 Aug 2022 https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm

6

Retrieved 02 Aug 2022 https://www.foxbusiness.com/economy/fed-starts-shrinking-balance-sheet-combat-sky-high-inflation

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