Federal Reserve’s Balance Sheet: Shrink It or Not?

by: Bob McTeer

“Fed Mulls Symbolic Shift” is the title of a front-page article in yesterday’s (8/3/10) Wall Street Journal. The question is whether the FOMC will reinvest money from its maturing mortgage-bond holdings “instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead.”

“Moving to stop the Fed’s portfolio from shrinking would prevent monetary policy from slightly tightening in the face of a weakening recovery.”
For a long time now people have been talking about the need for the Fed to “unwind” or “shrink” its balance sheet, sometimes, it is said, to pre-crisis levels. I don’t know what I’m missing. Significant shrinking of the balance sheet would be a draconian tightening of monetary policy. It would be way more than a “symbolic shift.”

I’m reminded of a comment my professor made that, if a truck runs over you, the appropriate remedy is not for it to back up over you from the opposite direction. I think he was saying depression is not a proper cure for inflation.

The red-suited country comedian, Jerry Clower, made a similar point more colorfully in a story about playing football at Mississippi State. He and a teammate were mowed down by onrushing opponents. When Jerry started to get up, his teammate told him to lie back down, they may be coming back.

Shrinking the Fed’s assets shrinks the other side of its balance sheet by an equal amount, usually bank reserve deposits. Shrinking reserves will cause banks to shrink loans and investments until deposits shrink by a multiple of the reserve loss. The marginal reserve requirement is around 10 percent; so the multiplier would be 10. That is drastic.

It is so drastic, that it is rarely done, even on a small scale. An easier monetary policy usually involves more open market purchases to make money grow faster. A tighter monetary policy, however, usually means slower open market purchases rather than outright sales. Some temporary shrinkage of the reserve base of the banking system may be done with temporary repurchase transactions, but rarely are there outright sales of securities not designed to offset increases in other assets.

I’m sure the FOMC would like to gradually change the composition of the Fed’s portfolio, toward more traditional government securities. Whether that means selling mortgage bonds and replacing them with short-term Treasury bills or replacing them with longer-term treasuries makes little difference in terms of money creation. Bills would presumably be ignored as routine while bonds would prompt shouts of quantitative easing, but it’s a distinction without much difference.