What is the Federal Reserve’s balance sheet?

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One of the most esoteric aspects of Federal Reserve policy has proven to be the U.S. central bank’s most stimulative economic tool: 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 whether the Fed is raising or lowering interest rates, this behind-the-scenes aspect of Fed policy has major implications for the U.S. economy, the stock market, monetary policy and your pocketbook. It’s all coming to a head officially on June 15, when the balance sheet officially starts to shrink.

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. 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. Treasurys and other securities, on the other hand, are considered assets.

Securities held outright make up about 95 percent of the Fed’s total balance sheet. Nearly two-thirds are Treasury securities, including shorter-term Treasury bills, notes and bonds. Mortgage-backed securities make up another almost one-third.

The Fed, by law, can only purchase government-backed debt, but in severe emergencies, it’ll create a special “lending facility” that it’ll fund, along with funding from the Treasury Department as a backstop. Then, it’ll use that facility to purchase other types of debt, such as corporate or municipal bonds. Those special facilities are then listed on the Fed’s balance sheet, as they were in the aftermath of the coronavirus crisis.

As of June 14, the Fed’s balance sheet totaled $8.97 trillion.

How does the Fed’s balance sheet impact the economy?

The Fed’s balance sheet is important because officials use it to influence longer-term interest rates. When officials want to stimulate the economy, they buy more assets and expand their asset portfolio. When they want to restrict growth, they let assets roll off and shrink their balance sheet.

The balance sheet has drawn national attention since the Great Recession. In November 2008, then-Fed Chairman Ben Bernanke faced a financial panic. The Fed reduced interest rates to virtually zero, but that decision 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 the longer-term interest rates that the Fed doesn’t directly control with its benchmark federal funds rate, 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.

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.”

How the Fed used its balance sheet during the coronavirus crisis

The Fed was even bolder with its crisis interventions during the COVID pandemic, with three different iterations of QE combining to expand the balance sheet past $8.9 trillion.

After slashing interest rates to zero in an emergency meeting on March 15, 2020, the Fed didn’t even wait for more economic data to know it needed to get more aggressive with stimulating the economy. That same day, the Fed also said it would buy at least $500 billion in Treasury securities and $200 billion in agency mortgage-backed securities.

By March 23, 2020, the Fed effectively created an unlimited bond-buying program, with officials agreeing to buy those same assets “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.”

Beginning in June 2020, the Fed officially announced that it would purchase $80 billion worth of Treasury securities and $40 billion mortgage-backed assets a month.

The Fed also created new emergency lending programs, some of which purchased municipal bonds and corporate debt for the first time in Fed history. They also added up to expand the Fed’s portfolio.

Why the balance sheet matters for consumers

Consumers have the Fed to thank for the record-low mortgage rates during the pandemic. In the months after the Fed’s massive bond-buying program, the average cost of financing a home with a 30-year fixed mortgage dipped to as low as 2.93 percent in late January, according to Bankrate data.

But the next important phase in the Fed’s crisis response will soon come — normalizing policy. Because a massive balance sheet has a stimulative effect on the economy, the Fed will eventually approach normalizing it.

Officials announced in May that they would officially start shrinking their balance sheet in June. Instead of reinvesting the proceeds of maturity securities, the Fed will simply let those expired securities roll off, with the first batch set to mature by June 15. At the current pace, officials want $47.5 billion worth of securities to roll each month between June and August. Then, it will increase that amount to $95 billion by September.

If history is any guide, the process won’t be easy. The balance sheet normalization process has led to extreme market volatility even when officials took the process much more slowly. 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.

Recent market volatility might be mimicking that period, as investors prepare for a much more aggressive Fed to combat soaring inflation. The S&P 500 has tumbled nearly 22 percent to start the year, officially entering bear market territory on June 13. Treasury yields also followed suit, with the 10-year rate soaring Tuesday to an 11-year high of 3.49 percent a day after making its biggest one-day move since March 17, 2020. The 2-year yield rose to 3.43 percent, the highest since November 2007.

That tightening spreads throughout the economy and is no doubt a major reason why the average 30-year fixed rate mortgage has risen more than 2 percentage points since December 2020, according to Bankrate data.

The normalization process also risks disrupting the flow of credit if the Fed takes the process too far. That’s essentially what happened in September 2019, when interest rates skyrocketed in a complicated corner of the marketplace: the repo, or repurchase agreement, market.

The repo market is a place where financial firms go for short-term loans, exchanging cash for securities. Trillions of dollars in debt are financed here, including U.S. government debt. Experts say the Fed’s balance sheet normalization process played an important role in the dysfunction.

“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.”

What next steps should consumers take?

The Fed’s balance sheet policies are often wrought with unknowns. All of this underscores the importance of tuning out volatility and maintaining a long-term mindset with your investments, as well as building up an emergency fund. The Fed’s even faster withdrawal of stimulus could lead to higher longer-term borrowing rates, such as mortgages, underscoring the importance of shopping around.

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.”

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.”