The U.S. Federal Reserve’s balance sheet consists of the Fed’s portfolio of U.S. Treasury and government-guaranteed mortgage-backed securities (MBS).
The balance sheet is one of the Federal Reserve’s main instruments for conducting monetary policy and for fulfilling the Federal Reserve’s dual mandate that requires it to ensure both stable prices and maximum employment.
The traditional tool the Fed used to accomplish these goals was the adjustment of the federal funds rate, the short-term interest rate that determined how much it costs for banks to lend to each other overnight.
The 2007-2008 financial crisis, however, demonstrated that even lowering the interest rate to zero was considered insufficient to shore up economies in freefall, and the Fed turned to more unusual tactics.
One of these measures was what the Fed refers to as “large-scale asset purchases,” which is more commonly known as “quantitative easing.” Just as with any other firm, securities that the Fed purchases through quantitative easing are considered assets and therefore are represented on the Fed’s balance sheet.
The value of the balance sheet of the Federal Reserve increased overall since 2007, when it stood at roughly $0.9 trillion U.S. dollars.
As of September 6, 2022, the Federal Reserve had $8.82 trillion U.S. dollars of assets on its balance sheet.
This dramatic increase can be traced back to two black swan events that had a disastrous impact on the U.S. economy:
- the 2008 financial crisis and
- the COVID-19 pandemic,
Both events led to a negative annual growth of the real gross domestic product (GDP) of the United States, writes Thomas Wade is the Director of Financial Services Policy at the American Action Forum. Therefore, the Federal Reserve’s response to these crises was to adopt expansionary monetary policies to stimulate employment and economic growth.
Increasing the money supply — an expansionary monetary policies which intends to increase the amount of money circulating in the economy — tends to increase inflation, states Statista.com, which destabilizes the economy and erodes purchasing power. Currently, the inflation rate in the United States reached 8.5 percent in 2022, the largest value in four decades.
Bottomline is that by expanding its balance sheet—i.e., by buying government bonds and MBS—the Fed expands the nation’s money supply in the hope of lowering interest rates and stimulating the economy; contracting the balance sheet should have the opposite effect.
However, by expanding the money supply too much, the Fed ran the risk of igniting inflation [“Inflation is one form of taxation that can be imposed without legislation.” Milton Friedman], while overly contracting it may stifle economic activity, including increasing unemployment and triggering an economic recession.
Inflation’, quipped Milton Friedman, ‘is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.
Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today.
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