The Federal Reserve System is the central bank of the United States and is responsible for the nation's monetary policy. The Fed's primary goals are to promote maximum employment, stable prices, and manage long-term interest rates. The Fed also helps to create stability in the financial system, especially during times of recession—or negative economic growth—and financial instability.
The Fed uses various programs and initiatives to accomplish its goals, and the result usually leads to a change in the composition of the Fed's balance sheet. The Fed can increase or decrease the amount and scope of assets or liabilities on its balance sheet, which in turn, increases or decreases the money supply within the economy. However, some critics argue the Fed has gone too far and tried to do too much in response to recessions and crises.
- Like any business organization, the Federal Reserve maintains a balance sheet listing its assets and liabilities.
- The Fed's assets include various Treasuries and mortgage-backed securities purchased in the open market and loans made to banks.
- Liabilities for the Fed include currency in circulation and bank reserves held at commercial banks.
- During economic crises, the Fed can expand its balance sheet by buying more assets, such as bonds—called quantitative easing (QE).
The Balance Sheet of the Federal Reserve Bank
Just like any other balance sheet, the Fed's balance sheet consists of assets and liabilities. Each week, the Fed issues its H.4.1 report, which provides a consolidated statement of the condition of all the Federal Reserve banks, in terms of their assets and liabilities.
For decades, the Fed watchers have relied on movements in assets or liabilities of the Fed to predict changes in economic cycles. The financial crisis of 2007-08 not only made the Fed's balance sheet more complex, but it also aroused the interest of the general public. Before going into the details, it would be better to take a look at the Fed's assets first and then its liabilities.
For much of its history, the Fed's balance sheet was actually quite a sleepy topic. Issued every Thursday, the weekly balance sheet report (or H.4.1) includes items that might seem at first glance typical of most company balance sheets. It lists all assets and liabilities, providing a consolidated statement of the condition of all 12 regional Federal Reserve Banks.
The Fed's assets consist primarily of government securities and the loans it extends to its regional banks. Its liabilities include U.S. currency in circulation. Other liabilities include money held in the reserve accounts of member banks and U.S. depository institutions.
The weekly balance sheet report became popular in the media during the financial crisis starting in 2007. When launching their quantitative easing in response to the ongoing financial crisis, the Fed's balance sheet gave analysts an idea of the scope and scale of Fed market operations at the time. In particular, the Fed's balance sheet allowed analysts to see details surrounding the implementation of an expansionary monetary policy used during the 2007-2009 crisis.
The Fed's Assets
The essence of the Fed's balance sheet is similar to any other balance sheet since anything for which the Fed has to pay money becomes the Fed's asset. In other words, if the Fed were to hypothetically buy bonds or stocks by paying newly issued money for it, those investments would become assets.
Traditionally, the Fed's assets have mainly consisted of government securities, such as U.S. Treasuries and other debt instruments. More than 60% or $4 trillion of the $7.34 trillion in assets include various types of U.S. Treasuries as of Jan. 07, 2021. The Treasury securities include Treasury notes, which have maturity dates that range from two to 10 years, and Treasury bills, or T-bills, which have short-term maturities such as four, eight, 13, 26, and 52 weeks.
The other significant amount of assets on the Fed's balance sheet include mortgage-backed securities, which are investments that are made up of a basket of home loans. These fixed-income securities are packaged and sold to investors by banks and financial institutions. The Fed owns more than $2 trillion in mortgage-backed securities on its balance sheet as of Jan. 07, 2021.
The assets also include loans extended to member banks through the repo and discount window. The Fed's discount window is a lending facility for commercial banks other depository institutions. The Fed charges an interest rate—called the federal discount rate—to banks for borrowing from the Fed's discount window. When the Fed buys government securities or extends loans through its discount window, it simply pays by crediting the reserve account of the member banks through an accounting or book entry. In case member banks wish to convert their reserve balances into hard cash, the Fed provides them dollar bills.
Thus, for the Fed, assets include securities it has purchased through open market operations (OMO), as well as any loans extended to banks which will be repaid at a later time. The open market operations refer to when the Fed buys and sells securities in the market, which are usually U.S. Treasury securities. Whether the Fed buys or sells securities, the central bank influences the money supply in the U.S. economy.
The Fed's Liabilities
One of the interesting things about the Fed's liabilities is that currency in circulation, like the green dollar bills in your pocket, are reflected as liabilities. Apart from this, the money lying in the reserve account of member banks and U.S. depository institutions also forms a part of the Feds' liabilities. As long as the dollar bills lie with the Fed, they would be treated as neither assets nor liabilities. The dollar bills become the Fed's liabilities only when the Fed puts them in circulation by purchasing assets. Of the nearly $7.3 trillion in liabilities as of Jan. 07, 2021, the Fed has just over $2 trillion as currency notes and nearly $5 trillion in deposits on its balance sheet.
The size of different components of the Fed liabilities keeps on changing. For instance, if the member banks wish to convert the money lying in their reserve accounts into hard cash, the value of the currency in circulation would increase, and the credit balance in reserve accounts would decrease. But overall, the size of the Fed's liabilities increases or decreases whenever the Fed buys or sells its assets.
The Fed also requires commercial banks to hold on to a certain minimum amount of deposits, known as reserves. The reserve ratio is the portion of reservable liabilities that commercial banks must hold onto rather than lend out or invest and is currently set at 0% effective March 26, 2020. As this is an asset for commercial banks, it is reciprocally a liability for the central bank.
The Meaning of Liability
The Fed can very well discharge its existing liabilities by creating additional liabilities. For instance, if you take your $100 bill to the Fed, it can very well pay you back in five 20-dollar bills or any other combination you like. The Fed can't, in any manner, be compelled to discharge its liabilities in terms of any other tangible goods or services. At best, you could receive government securities by paying back in dollars whenever the Fed is selling. Beyond this, the Fed's liabilities are only as good as something written on a piece of paper. In a nutshell, paper promises beget only other kinds of paper promises.
The Fed's Balance Sheet Expansion
Theoretically, there is no limit up to which the Fed can expand its balance sheet. The balance sheet of the Fed automatically expands when the Fed buys assets. Likewise, the Fed's balance sheet automatically contracts when it sells them. However, contraction of a balance sheet differs from expansion in the sense that there is a limit beyond which the Fed can't contract its balance sheet. That limit is determined by the value of assets. Unlike dollar bills, which can be used for buying assets, the Fed can't create government securities out of thin air. It can't sell more government securities that it owns.
Apart from this, while expanding or contracting its own balance sheet, the Fed has to also take into account its effect on the economy. Generally, the Fed buys assets as a part of its monetary policy action whenever it intends to increase the money supply for keeping the interest rates closer to the Federal funds rate, and sells assets when it intends to decrease the money supply.
Quantitative easing (QE) is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market to lower interest rates and increase the money supply. Using the Fed's balance sheet through quantitative easing remains somewhat controversial. Although these efforts certainly helped ease the bank sector's liquidity issues during the financial crisis, critics contend QE was a giant drawback and was a distortion of free-market principles. Today, markets are still sorting out the short-term bump but longer-term side effects of the government stepping in.
The Fed's Programs
Sometimes the Fed has to take steps out of its normal course, as it did during the 2007-08 financial crisis and the response to the coronavirus pandemic.
Financial Crisis of 2007-2008
During the height of the financial crisis, the Fed's balance sheet ballooned with toxic assets having different kinds of acronyms. The Fed had assets worth $870 billion on its books toward the end of August 2007, just before the start of the financial crisis, and the same stood at $2.23 trillion at the end of 2009.
So we have seen Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF), and many other complex acronyms reflected as the Fed's assets over a period. Some argued that the Fed intervention in this manner helped in putting markets back on track.
Coronavirus Pandemic of 2020 and 2021
In response to the economic hardship facing the United States due to the coronavirus pandemic, the Fed took several steps to stabilize and support the banking system, corporations, and small businesses.
The Fed's stimulus actions were carried out through multiple lending facilities, including the Paycheck Protection Program Liquidity Facility (PPPLF), which provided money to financial institutions so that they could lend that money to small businesses.12 The Main Street Lending Program was another lending program that helped to provide loans to small and mid-sized companies, but the program ended on January 8, 2021.
The Fed also directly purchased existing investment-grade corporate bonds of U.S. companies—called the Secondary Market Corporate Credit Facility (SMCCF). In addition to corporate bonds, the Fed also bought exchange-traded funds (ETFs)that contained bonds.
The Fed's purchases created an enormous demand for corporate debt, allowing companies to issue new bonds to raise capital or money. All of these actions increased the Fed's balance sheet from $4.7 trillion on March 17, 2020, to over $7.3 trillion by January 5, 2021.
All of us are connected to the Fed's balance sheet in one way or another. The currency notes that we hold are liabilities of the Fed while U.S. Treasuries, which are popular fixed-income investments, are held as assets. Any action by the Fed to increase or decrease the assets and liabilities on its balance sheet can ultimately have a significant impact on all consumers and businesses within the United States.