The Fed’s Balance Sheet and Possible Exit Strategies

The Federal Reserve balance sheet has expanded in size and deteriorated in quality, raising concerns about the difficulty of rolling back the Fed’s monetary easing—particularly as its outright asset purchases overtake temporary credit on the asset side of its balance sheet. Worse yet, many of these asset purchases have long maturities. Despite the sharp rise in reserves deposited at the Fed and lower market interest rates, private-sector credit growth remains stagnant. Given current economic conditions, the time to tighten monetary policy might not be here yet. The risk could be a reprisal of 1937, when premature fiscal and monetary tightening pushed the U.S. back into a recession during the Great Depression.

If the U.S. does dip back to lower growth, the Fed may have to consider further easing—such as an increase in Treasury purchases or a reduction in nominal interest rates below zero. When the U.S. returns to a path of sustainable growth, the Fed may struggle with selling off assets acquired through quantitative easing. Raising the interest the Fed pays on excess reserves may help keep excess liquidity from turning into high inflation, though the Fed alone may not be enough to maintain price stability. Regulation of non-bank financial institutions, such as capital requirements on hedge funds, might also be needed to keep asset inflation under control. Regardless, image control will be of utmost importance to the Fed in order to prevent inflation expectations from driving up interest rates too high, too soon.

The following report looks at the size and composition of the Fed’s balance sheet, the effects of balance-sheet expansion and future paths for the Fed.

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