Understanding the Federal Reserve’s Balance Sheet

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When examining the balance sheet of the Federal Reserve, or any central bank for that matter, it’s akin to witnessing the eighth wonder of the world. Unlike ordinary businesses or banks, the Fed can expand its balance sheet by printing as much money as it deems fit. It’s akin to creating wind by merely waving one’s hand.

However, there are practical limitations, and printing more money may not always be beneficial for the economy. In this article, we’ll navigate through the intricacies of the Fed’s balance sheet so that you can grasp it without feeling perplexed.

Assets and Liabilities

Similar to any other balance sheet, the Fed’s balance sheet comprises assets and liabilities. Every Thursday, the Fed releases its weekly H.4.1 report, providing aggregated data on the condition of all Federal Reserve Banks regarding assets and liabilities of member banks. For decades, Fed watchers have relied on fluctuations in the Fed’s assets or liabilities to forecast changes in the economic cycle. The financial crisis of 2007-08 not only made the Fed’s balance sheet more complex but also heightened public interest in it. Before delving into details, it’s prudent to examine the Fed’s assets first and then its liabilities.

Assets of the Fed

The essence of the Fed’s balance sheet is quite straightforward. Anything that the Fed has to pay for becomes its asset. So, if the Fed purchases scrap metal by paying for it, that pile of junk becomes its asset. Traditionally, the Fed’s assets mainly consist of government securities and loans extended to member banks through the repo and discount windows. When the Fed buys government securities or extends loans through the discount window, they merely settle by crediting the reserve account of member banks via a bookkeeping entry. In case member banks wish to convert their reserve balances into physical cash, the Fed provides them with dollar bills.

Endless Expansion

In theory, there’s no limit to how much the Fed can expand its balance sheet. The Fed’s balance sheet will automatically expand as it buys assets. Likewise, the Fed’s balance sheet will automatically contract when it sells them. However, the contraction of the balance sheet differs from expansion in the sense that there’s a limit beyond which the Fed cannot shrink it further. That limit is determined by the value of assets. Unlike dollars, which can be used to buy assets, the Fed cannot create government bonds out of thin air. It cannot sell more government bonds than it owns.

Moreover, while expanding or contracting the balance sheet, the Fed also has to consider the impact on the economy. Generally, the Fed buys assets as part of monetary policy actions whenever it intends to increase the money supply to keep interest rates close to the Fed’s long-term target rate and sells assets when it intends to decrease the money supply.

Tools of Mass Protection

But sometimes, even the Fed has to take bold steps, as it did during the 2007-08 financial crisis. During the financial crisis period, the Fed’s balance sheet ballooned with various toxic assets. The Fed held assets worth $870 billion on its books in the week ending August 1, 2007, just before the onset of the financial crisis, and it soared to $2.23 trillion by the end of 2009 (as of March 2020, it’s $4.75 trillion). Interventions in toxic assets helped stabilize everything and prevent a wholesale collapse.

Liabilities of the Fed

One of the intriguing aspects of the Fed’s liabilities is that some assets you hold, such as greenback bills in your wallet, are reflected as liabilities of the Fed. Additionally, the money in the reserve accounts of member banks and depository institutions is also part of the Fed’s liabilities. As long as dollar bills remain with the Fed, they are neither assets nor legal obligations of the Fed. Dollar bills become liabilities of the Fed only when the Fed puts them into circulation by purchasing assets. The composition of the Fed’s liabilities is continually changing. For example, if member banks want to convert money in their reserve accounts into physical cash, the amount of currency in circulation will increase, and the balance of credit in reserve accounts will decrease. In general, the scale of the Fed’s liabilities increases or decreases whenever the Fed buys or sells its assets.

Significance of the Liabilities Side

The Fed can pay off its current liabilities very well by creating additional liabilities. For instance, if you present your $100 bill to the Fed, the Fed can give you back five $20 bills or any other denomination you prefer. The Fed cannot settle its liabilities with any tangible goods or services. At best, you can receive government bonds by returning the Fed the dollar bill. Apart from that, the Fed’s liabilities (the dollar bills you’re holding) are also merely numbers written on a piece of paper. In summary, a promise note can only be exchanged for other promise notes.

Conclusion

We are all connected to the Fed’s balance sheet in one way or another. The currency notes we hold are legal obligations of the Fed. Similarly, a portion of the money in our deposit accounts, held by commercial banks, in reserve accounts at the Fed, is reflected as liabilities of the Fed. Any shrinkage in the Fed’s balance sheet will eventually trickle down to our lives.