By Tom Burnett CFA
With help from the Research Department of the St. Louis Federal Reserve Bank, we will attempt to explain in broad outline form how the Fed manages its balance sheet assets and liabilities. The research materials from the St. Louis Fed are available on line for readers who would like more detail (www.research.stlouisfed.org) and the staff is very accommodating in response to questions.
Looking at the latest Fed balance sheet (Table H.4.1) , dated March 30, 2022, total assets amount to $8.9 trillion. Securities owned equal $8.5 trillion, of which Treasury securities holdings are $5.8 trillion. The primary liabilities are Currency in Circulation at $2.3 trillion, Reserve Balances held by commercial banks at $3.8 trillion, and Treasury Capital Account deposits at $450 billion. The Fed has made it very clear in several public announcements that it intends to shrink the balance sheet which is now $3.8 trillion higher than it was a year ago.
The Fed can take two actions to reduce its holdings and the size of the balance sheet. One, it can sell securities in the open market. These sales proceeds come from the purchasing bank’s Reserve Balances at the Fed (banks must keep a certain small percentage of their deposits on reserve with the Fed). In this case, the assets go down as securities are sold, and an equal amount of liabilities decrease to pay for the purchase. Accordingly, the Fed balance sheet shrinks by the amount of the sale.
The second action the Fed may take is to let the bond holdings mature. In that case, the assets decline and the Treasury, in paying off the maturing securities, uses its Capital Account balance to make the payment. Again, assets and liabilities decline by the same amount and the balance sheet totals are reduced on both sides of the statement.
Investors should expect upward pressure on interest rates from the balance sheet shrinkage, since assets are taken out of the market place or the Treasury’s available spending funds. In addition, under the first action, as commercial banks’ reserves decline, they must replace them against deposits, reducing funds that could have been utilized in making new loans. As such, the ultimate results of the balance sheet shrinkage may be an economic slowdown which would eventually act to lower interest rates. No one wants to see an economic slowdown, but investors must remain alert to the ‘unintended consequences’ of a determined Fed action to shrink its $9 trillion balance sheet.
Tom Burnett CFA is Director of Research