Federal Reserve's Huge Balance Sheet Poses Risk

April 30, 2013

When the housing market collapsed in 2007, bringing with it much of the financial industry, the Federal Reserve had to take drastic actions to protect the economy. These actions included lowering interest rates, asset acquisitions and successive rounds of quantitative easing. The result is that the Federal Reserve now has an enormous balance sheet that could take nearly 10 years to normalize, says the Wall Street Journal.

  • The Fed is expected to continue its current path of stimulus and purchasing of Treasury and mortgage bonds through the third quarter of 2014.
  • If this occurs, the Fed's balance sheet will not return to its historical norm of around 6 percent of gross domestic product until 2022.
  • Goldman Sachs expects that the balance sheet, which is now just over $3 trillion, will top out at around $4 trillion when the Fed feels confident enough about the U.S. economic outlook to end its current strategy of bond purchases.

The Fed has said that it will not sell any assets soon, meaning the balance sheet is unlikely to shrink as the central bank continues to engage in its monthly purchase of $85 billion of Treasury and mortgage debt.

  • The purchases are aimed at boosting growth, lowering unemployment and providing liquidity.
  • While many Fed officials continue to support asset acquisition, some officials believe the purchases should stop due to fears that the excessively stimulative policy could create new asset bubbles.
  • Other officials are worried about inflation and the risk of outright deflation occurring, which could mandate even more bond buying.

Central bankers, like investors and the American public, are unsure about the future of the U.S. economy. The fate of the Fed's balance sheet is largely unknown and the size of the Fed's balance sheet is certainly reason to worry. The unprecedented size of Fed holdings could create inflation in the future, which to fix would require economic tools that the Fed has never employed outside of economic models.

When the Fed increased its bond buying two years ago, it said that bond sales would be a primary tactic to tighten policy. Whether the market could handle the volume is unknown.

Source: Michael Derby, "Fed's Balance Sheet Could Take Nearly 10 Years to Normalize," Wall Street Journal, April 23, 2013.

 

Browse more articles on Economic Issues