(NovaPoint) The Federal Reserve’s balance sheet has assets and liabilities similar to any other bank balance sheet. The Fed can increase or decrease the size of its balance sheet as a tool to meet its core mandates of full employment and price stability, as well as maintaining the stability of the financial system.
Prior to the economic crisis sparked by the COVID pandemic, the Fed’s balance sheet size was just over $4 trillion. The Fed acted aggressively to backstop the financial system by purchasing U.S. Treasury and mortgage-backed securities. This helped lower interest rates, create financial liquidity for institutions and individuals, and allowed the government to put multiple financial support mechanisms in place to ease the burden brought on by the pandemic-driven business closures and social restrictions.
Now that the pandemic has eased the labor market has returned to near pre-pandemic levels, the Fed has been faced with fighting high levels of price inflation across most of the economy. The Fed has already stopped the bond purchases and has begun raising the Fed funds target rate to begin normalizing monetary policy. A third piece of this is reducing the size of the Fed’s balance sheet which increased to just under $9 trillion over the course of the pandemic. Through the open market operations conducted by the Federal Reserve Bank of New York, the Fed will begin selling up to $95 billion of fixed income securities per month beginning as early as next month. The Fed currently holds $5.8 trillion of U.S. Treasury securities and will sell up to $60 billion per month. The Fed also holds $2.7 trillion of mortgage-backed securities and will sell up to $35 billion per month.
The combination of higher short-term interest rates initiated by raising the Fed fund target rate and the open market sales of longer-term government and mortgage-backed bonds should raise interest rates across the yield curve in an effort to reduce liquidity and stem the rise in prices. The reduction in the Fed’s balance sheet is also a prudent action to let investors absorb the government debt securities and allow the Fed to save balance sheet capacity for the future.
