A More Realistic Look at the Fed's Balance Sheet

by: Bob McTeer

This is the year that the whole world apparently discovered the importance of the Fed's Balance Sheet. Unfortunately, their discovery was made when it suddenly doubled in the context of a sever financial panic. This is awful! Right? We've got to get it back down to size! Right?

The suddenness of these revelations prevented useful perspective on why the balance sheet is important and why the composition of the balance sheet is just as important as the size. Money and banking text books for decades have discussed the Fed's balance sheet in the context of bank reserves and the Fed has for decades provided a statistical release on "Factors Affecting Reserves."

The two main ways the Fed conducts monetary policy are to purchase and sell Treasury securities in the open market and to encourage or discourage discount lending to eligible institutions. Both these things add to or subtract from the Fed's total assets. But other purchases may also add to the Fed's total assets, such as building a new building or buying new computers. All expansion of assets may have monetary implications on the liabilities side of the Fed's balance sheet. The net effect of the other asset purchases on monetary liabilities are taken into account when the Fed conducts open market operations to deliberately affect bank reserves. For example, if it is buying lots of new main frame computers for the wire transfer or ACH systems, it would presumably buy fewer Treasury bills to achieve a given target expansion of bank reserves.

There is some justification, therefore, for looking at the sum of the assets on the Fed's balance sheet (which will equal the sum of its liabilities). The recent focus on the Fed's balance sheet, however, has been on total assets as if all the asset growth results in growth in bank reserves or the monetary base (reserves plus currency outstanding). There are nonmonetary liabilities on the Fed's balance sheet, however, that may rise or fall with the expansion or contraction of total assets without affecting monetary liabilities. To the extent that is the case, all the talk about the "doubling" of the Fed's balance sheet and how it has to be "unwound" exaggerates the problem and the difficulty of correcting the problem.

To put this in roughly textbook form, on the Fed's balance sheet, you have:

Total Assets = Monetary Liabilities + Other Liabilities,

Therefore:

Monetary Liabilities = Total Assets - Other Liabilities

Therefore in the Fed's H.4 release, assets are the factors supplying reserves and other liabilities are factors absorbing reserves. The difference represents the change in reserves. In other words, asset expansion may expand Fed liabilities other than bank reserves.

One easy example to illustrate the point that not all asset expansions are equally insidious, are central bank swaps, where we borrow foreign currencies and lend an equivalent amount of dollars to foreign central banks and agree to exchange back at the same rate some time in the future. Those transactions expand both the assets and the liabilities on The Fed's balance sheet without affecting monetary liabilities, and they can be reversed without affecting monetary liabilities.

In the future, when you hear extreme statements about the likely impact of the expansion of the Fed's balance sheet, check into its composition as well.