Understanding the Fed’s balance sheet

The Federal Reserve System is the central bank of the United States, responsible for the country’s monetary policy. The main goals of the Fed are to maximize employment, stabilize prices, and manage long-term interest rates. The Fed also helps to establish the stability of the financial system, especially during periods of economic recession or negative economic growth and financial instability.

The Fed uses various plans and measures to achieve its goals, and the results usually result in changes in the composition of the Fed’s balance sheet. The Fed can increase or decrease the number and scope of assets or liabilities on its balance sheet, thereby increasing or decreasing the money supply in the economy. However, some critics believe that the Fed has done too much in responding to recessions and crises and has tried to do too much.

Key points

  • Like any business organization, the Federal Reserve maintains a balance sheet, listing its assets and liabilities.
  • The Fed’s assets include various Treasury bonds and mortgage-backed securities purchased on the open market, as well as loans provided to banks.
  • The Fed’s liabilities include currency in circulation and bank reserves held by commercial banks.
  • During an economic crisis, the Fed can expand its balance sheet by buying more assets (such as bonds). This is called quantitative easing (QE).

Federal Reserve Bank’s balance sheet

Just like any other balance sheet, the Fed’s balance sheet is composed of assets and liabilities. Every week, the Federal Reserve releases its H.4.1 report, which provides a comprehensive statement of the assets and liabilities of all Federal Reserve banks.

For decades, Fed observers have been relying on changes in the Fed’s assets or liabilities to predict changes in the business cycle. The 2007-08 financial crisis not only made the Fed’s balance sheet more complicated, but also aroused public interest. Before discussing the details, it is best to look at the Fed’s assets and then its liabilities.

For most of its history, the Fed’s balance sheet has actually been a rather boring topic. The weekly balance sheet report (or H.4.1) released every Thursday includes items that at first glance seem to be typical of most company balance sheets. It lists all assets and liabilities and provides a consolidated statement of the status of all 12 regional Federal Reserve banks.

The Fed’s assets mainly include government securities and loans provided to regional banks. Its liabilities include U.S. dollars in circulation. Other liabilities include funds in reserve accounts of member banks and US depository institutions.

Weekly balance sheet reports became popular in the media during the 2007 financial crisis. When introducing quantitative easing policies in response to the ongoing financial crisis, the Fed’s balance sheet allows analysts to understand the scope and scale of the Fed’s market operations. time. In particular, the Fed’s balance sheet allows analysts to see the implementation details surrounding the expansionary monetary policy used during the 2007-2009 crisis.

Fed assets

The nature of the Fed’s balance sheet is similar to any other balance sheet, because any fees the Fed must pay will become an asset of the Fed. In other words, if the Fed buys bonds or stocks by paying for newly issued funds, these investments will become assets.

Treasury Securities

Traditionally, the Fed’s assets consist mainly of government securities, such as U.S. Treasuries and other debt instruments. As of March 17, 2021, of the US$7.69 trillion in assets, more than 60%, or nearly US$5 trillion, include various types of US Treasury bonds. US Treasury bonds include Treasury bills and Treasury bills with maturities ranging from 2 to 10 years, or short-term Treasury bills, such as 4, 8, 13, 26, and 52 weeks.

Mortgage-backed securities

Other important assets on the Fed’s balance sheet include mortgage-backed securities, which are investments made up of a basket of housing loans. These fixed-income securities are packaged and sold to investors by banks and financial institutions. As of March 17, 2021, the Federal Reserve has more than $2 trillion in mortgage-backed securities on its balance sheet.

loan

These assets also include loans provided to member banks through repurchase and discount windows. The Fed’s discount window is a lending tool for commercial banks and other depository institutions. The Fed charges banks the interest rate on borrowing from the Fed’s discount window (called the federal discount rate).

When the Fed purchases government securities or provides loans through its discount window, it only needs to pay by accounting or book entries into the reserve accounts of member banks. If member banks want to convert their reserve balances into cash, the Federal Reserve will provide them with U.S. dollar bills.

Therefore, for the Fed, assets include securities purchased through open market operations (OMO) and any loans provided to banks that will be repaid in the future. Open market operations refer to the Fed buying and selling securities in the market, usually U.S. Treasury bonds. Whether the Fed buys or sells securities, the central bank will affect the money supply in the U.S. economy.

Fed’s responsibilities

One of the interesting things about the Fed’s liabilities is the currency in circulation. Like the green dollar bill in the pocket, it is reflected as a liability. In addition, the funds that exist in the reserve accounts of member banks and US depository institutions are also part of the Fed’s liabilities. As long as U.S. dollar bills belong to the Federal Reserve, they are not considered assets or liabilities.

Only when the Fed puts them into circulation by purchasing assets, the dollar bills become a liability of the Fed. As of March 17, 2021, out of nearly 7.65 trillion U.S. dollars in liabilities, the Federal Reserve’s currency bills only exceed 2 trillion U.S. dollars, and the balance sheet deposits are 5.3 trillion U.S. dollars.

The size of the different components of the Fed’s liabilities is constantly changing. For example, if a member bank wishes to convert the currency in its reserve account into cash, the value of currency in circulation will increase and the credit balance in the reserve account will decrease. But in general, as long as the Fed buys or sells its assets, the size of the Fed’s liabilities will increase or decrease.

The Federal Reserve also requires commercial banks to hold a certain minimum deposit, or reserve. The reserve requirement ratio is part of the reserveable liabilities that commercial banks must hold rather than lend or invest. It is currently set at 0% and will take effect on March 26, 2020. Since this is an asset of a commercial bank, it is also a liability to the central bank.

The meaning of responsibility

The Fed can well pay off its existing liabilities by creating additional liabilities. For example, if you hand over a 100-dollar bill to the Federal Reserve, it can repay you well with five 20-dollar bills or any other combination you like. The Fed cannot be forced to fulfill its responsibilities for any other tangible goods or services in any way. At best, as long as the Fed sells, you can obtain government securities by repaying them in U.S. dollars.

Other than that, the Fed’s liabilities are as good as something written on a piece of paper. In short, paper promises will only produce other kinds of paper promises.

Fed’s balance sheet expansion

In theory, there is no limit to the Fed’s ability to expand its balance sheet. When the Fed buys assets, the Fed’s balance sheet automatically expands. Similarly, the Fed’s balance sheet automatically shrinks when it is sold.

However, contraction of the balance sheet is different from expansion because there is a limit to the Fed’s inability to shrink its balance sheet. The limit is determined by the value of the asset. Unlike U.S. dollar bills that can be used to purchase assets, the Fed cannot create government securities out of thin air. It cannot sell more government securities it owns.

In addition, while expanding or shrinking its own balance sheet, the Fed must also consider its impact on the economy. Generally speaking, the Fed buys assets as part of its monetary policy actions when it intends to increase the money supply to keep interest rates close to the federal funds rate, and sells assets when it intends to reduce the money supply.

Quantitative easing (QE) is an unconventional monetary policy in which the central bank purchases government securities or other securities from the market to lower interest rates and increase the money supply. The use of the Fed’s balance sheet through quantitative easing is still somewhat controversial. Although these efforts did help to alleviate liquidity problems in the banking sector during the financial crisis, critics believe that quantitative easing is a huge shortcoming and a distortion of free market principles. Today, the market is still dealing with the short-term shocks and long-term side effects of government intervention.

Fed plan

Sometimes, the Fed has to take some unusual measures, as it did during the 2007-08 financial crisis and the response to the coronavirus pandemic.

2007-2008 financial crisis

During the worst of the financial crisis, the Fed’s balance sheet was inflated by toxic assets with different acronyms. As of the end of August 2007, on the eve of the financial crisis, the value of assets on the Fed’s books was US$870 billion, and at the end of 2009, this figure was US$2.23 trillion.

As a result, we have seen the periodical auction facility (TAF), primary dealer credit facility (PDCF) and many other complex acronyms reflected as Fed assets for a period of time. Some people believe that the Fed’s intervention in this way will help get the market back on track.

2020 and 2021 COVID-19 pandemic

In response to the economic difficulties faced by the United States due to the coronavirus pandemic, the Federal Reserve has taken a number of measures to stabilize and support the banking system, businesses, and small businesses.

The Fed’s stimulus actions are implemented through a variety of lending tools, including the Payroll Protection Program Liquidity Facility (PPPLF), which provides funds to financial institutions so that they can lend funds to small businesses. The Main Street Lending Program is another loan program that helps provide loans to SMEs, but the program ends on January 8, 2021.

The Fed also directly purchased existing investment-grade corporate bonds of US companies called the Secondary Market Corporate Credit Facility (SMCCF). In addition to corporate bonds, the Federal Reserve also purchases exchange-traded funds (ETFs) that include bonds.

The Fed’s purchases created a huge demand for corporate debt, allowing companies to issue new bonds to raise capital or capital. All these actions have increased the Fed’s balance sheet from US$4.7 trillion on March 17, 2020 to more than US$7.6 trillion on March 17, 2021.

Bottom line

All of us are related to the Fed’s balance sheet in some way. The currency bills we hold are liabilities of the Federal Reserve, while U.S. Treasury bonds are popular fixed-income investments and are considered assets. Any action taken by the Fed to increase or decrease the assets and liabilities on the balance sheet will ultimately have a significant impact on all consumers and businesses in the United States.

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