Fed Facts: What Is The Federal Reserve's Balance Sheet, And Why Does It Need To Shrink?

In the Federal Reserve's current tightening campaign, the Federal Open Market Committee has looked into shrinking the central bank’s balance sheet.

The median dealer expects the FOMC to allow the balance sheet to begin shrinking in the second quarter of 2018, according to the March survey of primary dealers by the New York Fed.

What Makes The Fed's Balance Sheet Unique?

The Federal Reserve's balance sheet is composed of assets and liabilities, but what makes it atypical is the Fed’s ability to print money. This process, known as quantitative easing, adds to the Fed’s assets.

For decades, Fed watchers have looked into the movement in both assets and liabilities to predict economic cycles.

The balance sheet expands when the Fed buys assets and contracts when it sells them. The Fed can always expand its balance sheet, but there is a limit beyond which the Fed can contract.

When expanding or contracting, the Federal Reserve tracks the economic effect of their changes. Almost everyone is connected to the Fed’s balance sheet. Thus, any movement in this balance sheet will have a ripple down effect on Americans.

How The Fed Amassed $4.5 Trillion In Assets

Following the financial crisis in 2008, the Fed started buying up long-term Treasuries and Federal National Mortgage Association FNMA and Federal Home Loan Mortgage Corp FMCC mortgage-backed securities, according to Forbes. The Fed did more of the same in 2010 and "doubled down" in 2012, leading to the Fed's balance sheet being five times the size it was in 2008, according to the magazine.

Overall, these policies have led to the Fed holding more than $4.5 trillion in assets.

Why Does The Balance Sheet Need To Shrink?

The FOMC has said that its current tightening campaign will involve a shrinking of the central bank’s balance sheet. While the committee has noted that this process will not be done until there are interest rates hikes, the Federal Reserve continues to discuss the topic. This leads some to speculate the process may start much sooner than initially expected.

The Fed is expected to shrink its balance sheet to avoid disruptions. In their 2014 formal guidance, the FOMC stated that “the balance sheet will ultimately be reduced, not by sales of assets that the Fed holds, but by ceasing or phasing out the Fed’s current practice of replacing or rolling over maturing assets.”

The FOMC believes this move will maximize predictability and minimize disruptions in the market. Additionally, by shrinking the balance sheet and making it more simple, it will allow the public to have a better understanding of FOMC interest rate projections.

“The degree of policy tightening implied by current interest rate projections depends on what’s happening with the balance sheet; if the size of the balance sheet is not tied to rate policy in a relatively straightforward way, then inferring the stance of policy implied by a given set of rate projections will be difficult or impossible," former Fed Chairman Ben Bernanke said in a Brookings Institution article in January.

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