Federal Reserve Balance Sheet Overload

The Federal Reserve Bank has been incredibly active recently. Due to a rising stability of growth in the economy, the FED has begun to make changes. The first change that economists cannot stop talking about is the increase in the federal funds rate by a quarter of a percent. The second change is creating a plan to decrease the rather large balance sheet the FED currently holds. Although increasing the federal funds rate is simple, deciding on how to decrease the balance sheet is much more difficult. However, with confidence in the economy, members of the FED are beginning to open up to the idea of revising the reinvestment policy.

As most economists learn in intro macro theory, the FED has many responsibilities, however the most important function is managing money flow through monetary policy. The balance sheet that the FED holds is large portfolio made up of assets and liabilities. The number in dollars of liability and assets the FED currently holds is $4.5 trillion. This exceptionally large number is primarily influenced by the crisis in 2008. In our standard IS-LM model, when the economy was hit with the 2008 recession, the IS curve shifted to the left significantly. To bring the economy back to a more stable state, fiscal policy was used to shift the IS curve close to its original state, however, it was nearly enough help. The FED then implemented monetary policy to shift the LM curve down. This shift in LM is what brought the federal funds rate down to 0. Out of necessity and effort to get the economy back on its feet as quickly as possible, the FED soaked up assets to stimulate reinvestment and job openings. Overall, buying a large amount of assets led to the huge increase of the balance sheet.

The problem now is decreasing the balance sheet. As mentioned above, the FED bought assets because they were taking monetary action to help increase the money supply in a recession. If the FED wants to reduce their balance sheet, they must sell these assets. However, this would cause a decrease in the money supply leading interest rates further away from the target Federal Funds rate. This ultimately brings up the complicated question of is the US economy ready for that? Or are there other ways? With all the activity going on in the FED, more news has yet to come. It is especially urgent given that Jannet Yellen’s term will be up in 2018.