(Bloomberg) - The Federal Reserve has to grapple with the question of how big its balance sheet should be after it stopped shrinking its $6.5 trillion portfolio, according to economists at the central bank.
Determining the optimal size of a central bank’s balance sheet involves a trade-off between a small size, low interest-rate volatility and limited market intervention, researchers Burcu Duygan-Bump and R. Jay Kahn wrote in a paper published Wednesday.
“Central banks face a ‘balance sheet trilemma’ in that they can achieve only two” of these goals at once, the researchers wrote. “The underlying tension between these goals is due to the financial sector’s demand for reserves and the frequency of sudden changes in liquidity demand and supply.”
In December, the Fed ended a more than three-year-long effort to reduce its holdings after stress signals in the $12.6 trillion short-term money markets intensified amid signs that bank reserves were no longer abundant.
At its peak in June 2022, the Fed’s balance sheet had swelled to as much as $8.9 trillion from just $800 billion nearly two decades earlier, driven by a series of large-scale asset purchase programs in response to the 2008 global financial crisis and the Covid-19 pandemic.
Central bank officials have appeared divided on how low they could take bank reserves to allow the balance sheet to return to its pre-crisis levels. Fed Vice Chair for Supervision Michelle Bowman has argued that the Fed should seek to achieve the smallest balance sheet possible.
In 2019, the central bank decided to move to a so-called ample-reserves regime by holding a sizable amount of Treasuries. As part of the current operating system, it pays interest on the reserves that banks park with it, and for any cash that money market funds temporarily place at the Fed.
Last month, the Fed announced it would begin reserve management purchases to keep its stock of reserves at an ample level as money market rates remained elevated ahead of year-end pressures.
“The trilemma highlights that a central bank must decide to what extent changes in liquidity will be absorbed through its balance-sheet size, managed through frequent market interventions, or allowed to lead to rate volatility,” the Fed economists wrote.
They said that regardless of the choice, “the central bank will almost always have a footprint” whether it’s through its holdings or through market operations.
A large balance sheet increases the central bank’s structural footprint in financial markets, creating a cushion of safe and liquid assets to prevent short-term rate volatility without the need for regular Fed intervention.
Operating with leaner reserves would increase money market volatility, forcing market participants to adjust to liquidity pressures. But it could also weaken the Fed’s control over interest rates, complicating monetary policy transmission, especially in the event of an unanticipated shock, the authors wrote.
Policymakers could also opt to tolerate some interest rate volatility at times, such as quarter-end statement dates, and respond with extra market operations and a slightly larger balance sheet. However, the authors noted frequent use of the Fed’s tools could distort market signals, similar to concerns associated with a large balance sheet.
The appropriate steady-state size of the balance sheet “remains an open question, as there is no consensus among economists or policymakers on the issue,” the authors wrote.
By Alexandra Harris
