FED Balance Sheet Explained

By Catherine Chen

During the Federal Reserve’s March meeting, discussion arose over a plan to begin unwinding the balance sheet to more manageable levels. As the FED continues to raise interest rates in anticipation of reaching full-employment output, officials are also beginning to address the trillions of bonds the FED holds on its “balance sheet.”

In his speech in Mumbai on Thursday, New York FED President William Dudley made three key statements:

1. The balance sheet will start to wind down in late 2017 or early 2018.
2. The FED will reduce the balance sheet “in a very careful way.”
3. Instead of shrinking it to pre-recession levels, the balance sheet will still have some excess reserves.

The Federal Reserve headed into new waters in 2008 when it engaged in quantitative easing, a policy that involved large-scale purchases of assets such as mortgage-backed securities and U.S. treasury bonds. Aimed at combatting the 2008 recession by decreasing long-term borrowing costs, this new approach to monetary policy lowered interest rates to nearly zero. These extraordinarily low rates were intended to stimulate investment spending and move the economy toward lower unemployment and price stability. As a result, however, the FED’s balance sheet skyrocketed dramatically, reaching a $4.5 trillion value of bond holdings. Since then, the FED has also been reinvesting maturing securities and principal payments in an effort to keep the balance sheet high and interest rates low. 

Now that the economy has shown signs of recovery from the financial crisis and continues to expand, the FED must find its way back from its uncharted journey through the normalization of monetary policy. This entails returning the balance sheet and interest rates back to “normal,” or pre-2008 levels. The Federal Reserve can do this in two different ways. The first is to simply allow the bonds to mature and stop reinvestment. Over a few years, the balance sheet will begin to dwindle on its own. The second is to sell bonds back into the market, which may put pressure on the bond market and lead to instability. The former option is thus much more likely to occur. In both scenarios though, the failure to reinvest principal may decrease the demand for bonds and thus have a contractionary effect on the economy.  

Ultimately, the Federal Reserve hopes to return the balance sheet and interest rates back to normal levels so that monetary policy will be effective in counteracting future recessions. Traditionally, the FED increases and decreases interest rates by selling and buying bonds in order to influence the money supply and produce a contractionary or expansionary impact on the economy. At the moment, interest rates can barely go any lower, leaving the FED with limited tools if a crisis is to occur.

However, reducing the balance sheet does not come without risks. Although the FED has wanted to normalize interest rates for a while now, concerns over the slowly recovering economy has led to precaution. When the FED stops buying bonds and reduces the demand for bonds, the potential spike in long-term interest rates can destabilize markets.  

The key, then, is for the FED to gradually reduce and taper off its balance sheet--a process that can take many years. As always, the FED will continue to analyze economic conditions and make policy decisions from there.
​


Sources:
http://www.investopedia.com/insights/how-will-fed-reduce-balance-sheet/
http://www.cnbc.com/2017/04/06/fed-balance-sheet-what-happens-why-it-matters-what-could-go-wrong.html