Taking a look at the balance sheet of The Federal Reserve, or for that matter, any central bank, is like seeing the eighth wonder of the world. Unlike any other business enterprise, the Fed can expand its balance sheet by printing as many dollar bills as it wants. It's like creating winds merely by waving your hands.
But there are many practical limitations, and printing more money may not be always good for the economy. In this article, we take you through the nooks and crannies of the Fed's balance sheet so that you are able to navigate through it without getting bewildered. (For a primer on the components of a typical balance sheet, see Reading The Balance Sheet.)
It's All About Assets and Liabilities
Just like any other balance sheet, the Fed's balance sheet consists of assets and liabilities. On every Thursday, the Fed issues its weekly H.4.1 report, which provides 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 balance sheet more complex, but it also aroused the interest of general public in it. Before going into the details, it would be better to take a look at the Fed's assets first and then its liabilities.
The Fed's Assets
The essence of the Fed's balance sheet is quite simple. Anything, for which the Fed has to pay money, becomes the Fed's asset. So if the Fed is buying junk scraps by paying money, that would become its asset. Traditionally, the Fed's assets have mainly consisted of government securities and loans extended to member banks through the repo and 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 a book entry. In case member banks wish to convert their reserve balances into hard cash, the Fed provides them dollar bills.
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 the government securities out of thin air. It can't sell more government securities than it owns. (Learn more: How Will the Fed Reduce its Balance Sheet?)
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 target the Fed funds rate and sells assets when it intends to decrease the money supply.
A Weapon of Mass Protection
But sometimes even the Fed has to take steps out of its normal course, as it did during the 2007-08 financial crisis. During the height of financial crisis, the Fed's balance sheet ballooned with toxic assets having different kinds of acronyms. The Fed had assets worth $858 billion on its books in the week ended on August 1, 2007, just before the start of the financial crisis, and the same stood at $2.24 trillion at the end of 2009 (today it's $4.45 trillion). So we have seen Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF) and many other complex acronyms getting 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.
Liabilities of the Fed
One of the interesting things about the Fed's liabilities is that some of your assets, like the green dollar bills in your pocket, get reflected as the liabilities of the Fed. 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 are lying with the Fed, they would be treated neither as assets nor as liabilities of the Fed. The dollar bills become the Fed liabilities only when the Fed puts them in circulation by purchasing assets. 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 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.
What does it Mean to Have a 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 good or services. At best, you could receive government securities by paying back in dollars whenever the Fed is selling. Beyond this, the Fed 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.
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. Likewise, a part of money lying in our checking accounts which is kept by banks in their reserve accounts gets reflected as liabilities of the Fed. Any push or pull in the Fed's balance sheet would ultimately ripple down to our lives. We just need to get a better grip for our own good.
To learn more about the Fed, take a look at our in-depth Federal Reserve Tutorial.