One of the most esoteric aspects of Federal Reserve policy has proven to be the U.S. central bank’s most powerful weapon in fighting off recessions: the balance sheet.
But even though it’s hard to translate Fed speak into everyday English, this isn’t a topic to ignore. While most consumers focus on how the Fed impacts borrowing costs, this behind-the-scenes aspect of Fed policy has major implications for the U.S. economy, the stock market, monetary policy and your pocketbook.
Here’s everything you need to know about the Fed’s balance sheet, including what it is, why it’s important and how it could impact you.
What is the Fed’s balance sheet?
You probably have an idea of the different types of debts you may owe, such as student loans, credit cards or a mortgage. In accounting terms, those are considered liabilities. In contrast, the things you own — stocks, bonds or a house, for example — are considered assets.
The same goes for the Fed.
The Fed’s balance sheet is a financial statement updated weekly that shows what the U.S. central bank owes and owns. But most importantly, the Fed uses this tool to orchestrate and execute some of its nontraditional policies designed to prop up the economy during downturns, such as quantitative easing. The balance sheet expands to stimulate the economy, and it shrinks to stabilize it.
More officially, it’s the Fed’s H.4.1 statement.
The Fed’s assets and liabilities
U.S. paper currency, as well as money that commercial banks hold in accounts at the Fed, are counted as a liability. Assets, on the other hand, are things that the Fed has purchased, such as Treasurys.
Securities held outright, which are assets the Fed has purchased, make up about 88 percent of the Fed’s total balance sheet. Nearly two-thirds are Treasury securities, including shorter-term Treasury bills, notes and bonds. Federal agency debt and mortgage-backed securities make up another near quarter of the balance sheet’s total size.
The Fed’s 12 new emergency lending facilities, created in the aftermath of the coronavirus crisis which are helping prop up companies, states and municipalities with special financing options, are also listed on the Fed’s balance sheet.
As of July 2, the Fed’s balance sheet swelled to $6.98 trillion, down by about $33.87 billion as mortgage-backed securities rolled off its portfolio.
When the Fed buys these assets, they mark up banks’ reserve accounts at the Fed with cash in an equivalent value to the asset it purchased and put on its balance sheet.
Fed’s balance sheet chart
How does the Fed’s balance sheet help fight off recessions?
To help understand why the Fed’s assets have become an important part of its recession-fighting toolkit, a history lesson from the 2008 financial crisis is needed.
In November 2008, then-Fed Chairman Ben Bernanke faced a financial panic. The Fed reduced interest rates to virtually zero, but that still wasn’t enough to jump start an economy suffering its worst turmoil since the Great Depression.
To inject more life into the financial system, the Fed turned to unconventional and unprecedented measures: It started buying long-term Treasurys, federal agency debt and mortgage-backed securities to “increase the availability of credit” for home purchases and prop up the economy, according to a Fed statement from 2008. That was also supposed to lower interest rates even more, providing more stimulus to the economy and incentivizing more borrowing and lending.
These purchases were dubbed “quantitative easing,” or QE, by financial experts. The Fed, however, prefers “large-scale asset purchases,” says Joe Pavel, senior media relations specialist at the board of governors of the Fed.
This process caused the balance sheet to balloon. In August 2007, before the financial crisis hit, the Fed’s balance sheet totaled about $870 billion. By January 2015, after those large-scale asset purchases had occurred, its balance sheet swelled to $4.5 trillion. That’s more than a five-fold increase. By the time the Fed finished its normalization process, the balance sheet totaled $3.78 trillion. The Fed’s balance sheet is now more than twice that, sitting at about $7 trillion during its coronavirus response.
Before these measures, people weren’t interested in the Fed’s finances, says Kenneth Kuttner, a professor of economics at Williams College who has researched unconventional monetary policy.
“It was the most boring thing in the world — like watching paint dry,” Kuttner says. “Quantitative easing changed all that.”
What consumers should watch for
Here’s why it matters for consumers. The asset purchases were so unprecedented that Wall Street investors worried that the economy may suffer harm and grow more slowly if the Fed reduced its balance sheet through the normalization process too aggressively. That’s because it takes money out of the financial system. And just as interest rates typically fall when reserve supplies increase, the central bank risks lifting borrowing costs as it decreases reserves.
It was the fear that “maybe monetary policy is a bit more contractionary than indicated by the fed funds rate,” Kuttner says. As a result, some have claimed that the balance sheet normalization process amounts to policy tightening. Thus, it’s often been dubbed “quantitative tightening.”
The balance sheet normalization process has been one reason for extreme market volatility. For example, when Fed Chairman Jerome Powell said after a December 2018 Fed meeting that the quantitative tightening process was on “auto pilot,” investors grew jittery that the Fed may reign in the balance sheet too much, sending stocks to their worst December since the Great Depression.
It became apparent in September of 2019 that the Fed might indeed have shrunk its asset holdings too much — but not for the reason you might be thinking. The normalization process didn’t exactly slow down the economy as experts feared, but it played a role in an extremely technical, short-term disruption.
A large amount of cash started pouring in and out of a complicated corner of the marketplace: the repo market. A “repo” is a shorter word for “repurchase agreements,” and the repo market is a place where parties go to exchange cash for securities. Trillions of dollars in debt are financed here, including U.S. government debt.
Economists still don’t know what exactly caused the funding shortfall or why it happened. Part of it was the timing. Corporate tax payments came due, sucking cash out of the system, right as new Treasury debt was offered up to the marketplace. But other experts say the Fed’s balance sheet normalization process played an important role in the dysfunction.
When the Fed started selling off its balance sheet holdings, bank reserves subsequently declined. Officials knew the balance sheet would be larger, meaning more bank reserves, than had been the case before the Great Recession. Yet they didn’t know exactly how big it should be, despite thinking they chose an optimum level.
“The banks had less excess reserves to lend,” says Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “If we look back in hindsight, it was the case that the Fed reigned in the balance sheet too much.”
As a result, the Fed started injecting cash as soon as September 17 to pull down interest rates. It also started conducting overnight lending operations. But on October 4, it made a big announcement: It would start “organically” growing the balance sheet again, at an initial pace of $60 billion each month.
How is the Fed using its balance sheet in response to the coronavirus crisis?
The Fed’s balance sheet has been back in the spotlight thanks to the coronavirus pandemic. The U.S. central bank has taken some extraordinary measures to contain the economic fallout — some came from the 2008 crisis-era playbook, and others went well beyond.
Most notably to do with the balance sheet, the Fed has instituted an unlimited bond-buying program. It’s also increased those repo market operations, pledging to inject a trillion dollars a week, in some cases, if firms indeed need it.
The Fed has also created new emergency lending programs, some that are scooping up municipal bonds and corporate debt. Though the Fed isn’t technically allowed to buy non-government backed debt, it can get around those requirements through section 13(3) of the Federal Reserve Act of 1913.
In emergency situations, the Fed can create a facility designed to buy those special types of debt and then lend to it. That special facility then goes on the Fed’s balance sheet.
But is this QE?
But the Fed has been hesitant to call these emergency measures quantitative easing, despite its size and scope. Records of the Fed’s March meeting show that the operations aren’t designed to push down long-term interest rates, but rather to ensure that markets are functioning properly.
Yet, all of this could lead to lower long-term rates down the road, including the Fed’s repo operations, Ma says, whether that’s through the mortgage market or to other Treasury markets out on the yield curve.
What next steps should consumers take?
The Fed has discovered that its policies that depend on the balance sheet are wrought with unknowns.
It’s like “going into a forest that hasn’t been mapped before,” says Mark Hamrick, Bankrate’s senior economic analyst. The Fed “wasn’t sure what they’d find on the way in, and getting out of the woods is similarly fraught with unknowns.”
All of this volatility and uncertainty surrounding the depth and the breadth of the coronavirus recession, as well as the Fed’s responses, underscores the importance of building an emergency savings fund, Hamrick says. Experts recommend storing about six months of expenses in a fund, which could offset an emergency such as losing your job, but still be enough to complement what you’d receive in unemployment benefits.
But the biggest bottom line of all? Embrace the unconventional.
“Consumers, investors, savers and borrowers should think about this (quantitative easing) as one of the two main tools in the central bank’s toolbox to help adjust the strength of the U.S. economy,” Hamrick says. “It remains to be seen how the Fed will learn how best to employ it and whether there are unintended negative consequences from having invented and deployed it.”
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