ANALYSIS: The Fed Is Raising Rates, but What About the $8.3 Trillion Balance Sheet?

The Federal Reserve building in Washington, on March 19, 2019. (Leah Millis/Reuters)

News Analysis

All financial eyes will be on next week’s policy meeting of the Federal Open Market Committee (FOMC). The futures market is penciling in a quarter-point increase to the benchmark federal funds rate. But while all the focus among economists, investors, and market analysts is on interest rates, what about the Federal Reserve’s massive balance sheet?

Despite policymakers conveying to the public that they have taken a fast-and-furious approach to inflation-fighting monetary policy by raising the policy rate by 500 basis points since March 2022, they have yet to emulate this aggression regarding the enormous multitrillion-dollar balance sheet.

During the coronavirus pandemic, the balance sheet exploded 110 percent, hitting an April 2022 peak of $8.965 trillion. As part of its quantitative easing (QE) initiative, the Fed acquired trillions in Treasury securities, corporate bonds, and mortgage-backed securities. It had been on a gradual downward trend, with the institution allowing the bonds to mature. But the balance sheet spiked in the fallout of the banking turmoil this past spring, growing nearly $400 billion, to a seven-month high of $8.73 trillion. It took about five months, but the balance sheet finally slipped below $8.3 trillion, the level before the Silicon Valley Bank and Signature Bank failures.

Advocates say that the Fed’s direct intervention was critical in stopping a meltdown in 2008 and 2020. Others contend that there could be risks.

“This approach is not without risks. For the first time in its history, the Fed is regulator, supervisor, and now participant in the economy,” said Thomas Kingsley, the director of financial services policy at the American Action Forum, in a note.

Economists purport that the Fed playing this role could lead to market distortions and interrupt the flow of resource allocation, resulting in artificial gains in asset prices, the start of speculative asset bubbles, and incentives for investors to take on more risk. A chorus of experts also purports that an enormous balance sheet that is complemented by historically low interest rates can trigger market-wide dependency and financial instability. In addition, if the economy experiences another calamity, the Fed would have little room to respond because it is already overextended.

The State of Monetary Policy

Still, the balance sheet is a long way from returning to pre-crisis levels. There is an even much farther distance from where it was positioned prior to the Great Recession, when it stood below $1 trillion.

Officials anticipate that the Fed will trim the balance sheet by an annual pace of about $1 trillion. Chair Jerome Powell confirmed at an Economic Club of Washington appearance in February that “it will be a couple of years” before the balance-sheet tapering concludes. Moreover, rather than speeding up the process by selling bonds, Powell says the central bank will continue allowing Treasurys to mature.

Federal Reserve chairman Jerome Powell in Washington on Feb. 7, 2023. (Julia Nikhinson/Getty Images)

The balance sheet does not seem to matter as much for the typical person as the Fed’s tightening. And, in some cases, even Fed officials do not possess a modicum of consternation about the potential ramifications of the balance sheet.

“The balance sheet outlook should not affect decisions about monetary policy at this stage,” said Lorie Logan, president of the Federal Reserve Bank of Dallas, in a prepared speech at the Central Bank Research Association earlier this month.

Consumers’ indifference to the balance sheet might seem understandable since the rate hikes have forced shoppers to feel the tug on their wallets. Data produced by Wallet Hub confirm that the cumulative rate increases have cost credit-card holders approximately $40 billion in additional interest charges. The Fed’s last hike increased the cost of the average 30-year mortgage by more than $11,000 over the life of the loan. More than three-quarters of consumers say the Fed’s hikes have impacted their wallets.

That said, utilizing the balance sheet to institute monetary policy, be it acquiring Treasury securities or other assets, can increase or decrease the money supply in the U.S. economy and affect Americans’ purchasing power. So, as what occurred throughout the COVID-19 public health crisis, the Fed’s asset purchases injected money into the financial system and provided trillions in liquidity to bolster spending and facilitate lending.

From February 2020 to April 2022, the money supply surged 37 percent, hitting a peak of $21.7 trillion. This also meant that more than a third of all U.S. dollars ever created occurred in about two years. Meanwhile, as the Fed engaged in quantitative tightening, the money supply has been shrinking. Fed data highlight that the M2 money supply has contracted for six consecutive months, falling about 4 percent in May. The nation’s money stock is decreasing at the fastest pace since the Great Depression. But, like the balance sheet, the money supply is a long way from returning to pre-pandemic levels.

History shows that easing money supply growth has usually been followed by a recession. For example, leading up to both recessions in the 1970s, the money supply had been on a downward trend. Or, before the 1990–91 recession, the year-over-year percentage growth in the national money stock had been steadily tumbling.

Whether the United States enters a recession or not remains to be seen. So far, the country has been resilient in the face of rising interest rates, although there are signs of anemic, below-trend growth. But financial experts argue that the balance sheet might have a role to play in averting a recession or keeping growth steady.

“The Fed, ECB [European Central Bank], and BoE’s [Bank of England] balance sheets remain the elephant in the room, and they are the reason why economies don’t react efficiently to interest-rate hikes, and inflation doesn’t slow at the desired speed,” wrote Ipek Ozkardeskaya, the senior analyst at Swissquote Bank, in a June research note. Yes, the Fed, the ECB, and BoJ’s [Bank of Japan] combined balance sheet size has been shrinking since last year, but total assets remain indisputably HIGH—almost 50 percent higher than pre-pandemic levels. So, you bet, the higher rates don’t do much harm to the economy, except for those who have to renew their mortgages.”

Return on Investment

When the Federal Reserve created the roughly $7 trillion, the institution extended it to governments and financial markets, with the idea that the organization would receive the principal, plus interest, in the future.

In other words, the central bank expected to earn profits down the road and then transfer the funds to the Treasury Department.

In 2022, the Fed recorded more than $58 billion in net profits, although the regional central banks began reporting net losses across the system beginning in September. In 2021, it garnered close to $108 billion in profits.

But while this provides the U.S. government with more funds as it runs trillion-dollar deficits, critics warn that expanding the balance sheet and earning profits can lead to unintended consequences for the broader economy, from currency debasement to boom-and-bust cycles.