Not too big, not too small: The just-right Fed balance sheet

Federal Reserve Chairman Kevin Warsh has made it clear that he believes the Fed’s balance sheet has gotten far too big.

In fact, one of the five task forces he set up at the central bank to examine and advance monetary policy is focused on the size and impact of the Fed’s ample reserves. It currently sits at around $6.7 trillion, according to the latest weekly balance sheet report.

But it wasn’t always this big.

What is the balance sheet?

In short, the Federal Reserve’s balance sheet is how the Fed funds itself. Its ledger is made up of what the Fed owns, what it owes, as well as its assets and liabilities.

“Liabilities” in this case is all the money out in the economy. Assets are typically Treasury bonds or loans. And at the end of the day, those assets and liabilities balance out to zero.

Prior to the Great Recession in 2008, the Federal Reserve’s balance sheet sat around $800 billion.

“It used to be so simple,” said Emi Nakamura, an economist at the University of California, Berkeley. “Traditionally it was just, you know, Treasury bills and Treasury notes. It was very boring stuff.”

How did it get so big?

After the Great Recession, that boring stuff got way more interesting.

The Fed had already cut rates to the 0%-25% range, but the economy didn’t respond accordingly. So, the Fed reached into its back pocket and used its balance sheet to attempt to stimulate business lending and growth.

“There was a notion that markets for housing were distressed, and so the Fed started to buy various kinds of mortgage-backed securities. They started buying longer-term bonds,” said Nakamura.

Over the next decade, the Fed continued to inject trillions of dollars into the economy and by 2019, the balance sheet had grown to $3.5 trillion.

Originally, the Fed planned to shrink its investment back to pre-crisis levels, but the COVID-19 pandemic forced the Fed’s hand.

“There was a huge amount of quantitative easing, massive increases in the money supply,” said Nakamura. “And that really was a response to the fact that companies and banks massively increased their demand for money.”

And the Fed satisfied that demand in hopes of promoting business growth at a time of stagnation. By 2022, the Fed’s balance sheet reached its peak, nearing $9 trillion.

Former Fed Chair Jerome Powell then began slowly shrinking the balance sheet, unwinding assets from its reserves. And that is how the balance sheet reached its current level at $6.7 trillion.

The Fed’s target?

Unfortunately, there isn’t a magic number that makes a balance sheet perfect.

“I don't know how many billions of reserves that would entail. I don't want to say a number, but it would wouldn't be trillions. That that much I can safely say,” said George Selgin, a senior fellow at the Cato Institute.

And actually shrinking it, well that’s another story. It’s a delicate dance that takes time.

“It’s a process. It's got to be done gradually,” said Selgin. “Make sure you don't get occasional shortages, local shortages of reserves and interest rate spikes.”

The Fed already has first-hand experience with that volatility after it tried shrinking the balance sheet back in 2017, under supervision of former Chair Janet Yellen.

But the current task forces at the Federal Reserve will report back to Chair Kevin Warsh by the end of 2026. Hopefully, they’ll come up with a clearer path forward.