Commentary on Political Economy

Friday 8 December 2023


The Federal Reserve Has an $8 Trillion Secret


Joseph C. Sternberg

Dec. 7, 2023 4:38 pm ET

Federal Reserve Board Chairman Jerome Powell answers a question at a press conference in Washington, Nov. 1. Photo: kevin lamarque/Reuters

Investors are hoping Christmas will come early next week when the Federal Open Market Committee releases its latest projections about monetary policy. It’s hard to imagine they’ll get their wish that Chairman Jerome Powell will hint at big interest-rate cuts to come in 2024. Meanwhile, the rest of us won’t get our wish to know what the Fed intends to do with one of its most powerful tools.

At issue is the quarterly Summary of Economic Projections, the latest edition of which will be released Wednesday alongside the FOMC’s December policy statement. The centerpiece is the “dot plot” by which FOMC participants signal their guesses about the likely future path of interest rates—a graphic that provides fodder for market speculation (in all senses of the word) for days if not weeks.



Something will be missing, however: any mention of the central bank’s balance sheet. The Fed’s decision to expand its asset holdings after 2008 (and the accompanying liabilities it has created) exerts enormous influence over the economy. Yet Fed officials still resist giving the public any formal signals about how they plan to use this tool.

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Quantitative easing—the expansion of the central bank’s balance sheet via the Fed’s purchase of securities worth trillions of dollars in three rounds between 2008 and 2022—is one of the most controversial things the Fed has done since the 2008 financial panic. Quantitative tightening—the gradual process of allowing those securities to run off the balance sheet as they mature—has been a central plank of the Fed’s strategy for fighting inflation since spring 2022. These policies have had profound effects on the U.S. financial system and economy.

On the liability side of the balance sheet, the Fed has abandoned the pre-2008 system in which banks’ deposits of reserves at the central bank were modest and the trading of those reserves among banks served as an important market signal (and policy tool for the Fed). The Fed now says it expects to operate an “ample reserves” system in which banks face no scarcity of this important form of capital.

This is inseparable from quantitative easing. When the Fed bought assets, it increased banks’ reserve balances in exchange. So an expectation that banks will maintain permanently higher reserve balances implies a limit to quantitative tightening in the future. Yet the Fed struggles to estimate what the “correct” level of bank reserves may be. Officials miss an opportunity to solicit market feedback when they leave this out of the quarterly projections.

Unresolved questions hang over the asset side of the balance sheet as well. The most important: What does the Fed now believe is the appropriate mix of Treasury bonds and other assets, such as mortgage-backed securities, for its portfolio? Successive rounds of quantitative easing and then tightening tended to increase and reduce Fed holdings of Treasurys and private-sector debts roughly in a constant proportion to each other. As quantitative tightening proceeds, should or will the Fed accelerate its selloff of mortgage securities so it can return to the pre-2008 norm of holding only Treasurys?

The answer to that question could have a big impact on the economy. Witness how the Fed’s needless purchases of mortgage securities during the pandemic created a credit subsidy that fueled a house-price boom that’s still filtering through inflation data. The Fed is entirely silent on such questions in its quarterly communication to the public about the likely path of monetary policy.

Why does the central bank leave balance-sheet projections out of its quarterly communications if they’re so important? The embarrassing answer is that the Fed doesn’t really understand how its balance sheet works as a policy lever. Central bank officials’ explanations of and justifications for quantitative easing have shifted in kaleidoscopic fashion over the years. The inability to settle on a theory of what QE does to the economy and how it does it has thwarted any discussion of what the Fed should say about the policy.

Ordinarily, this columnist would view that restraint as a virtue, preferring that the Fed not say anything about the future at all. Forward guidance has been a notable flop as a policy tool, trapping the Fed in unsuitable policies as inflation gathered steam and then helping to stoke speculative manias and banking crises.

But if the Fed insists on using signal-sending as a policy tool, officials owe it to the public to give the whole truth. This would include adding a line or two to the first table of the quarterly projections, right below estimates of future short-term interest rates, to signal what FOMC members think will be an appropriate size of the balance sheet in future years and what assets the Fed should hold in order to achieve its policy goals.

If they don’t think they know the answers to those questions, why did they run up the Fed’s balance sheet in the first place?

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