The Fed Needs to Answer a Big Question About Its Balance Sheet

By Phillip Basil, Director of Economic Growth and Financial Stability

In response to the 2008 Financial Crisis and more recently the COVID-19 pandemic, the Fed grew its balance sheet tremendously – from less than $1 trillion to $4.2 trillion, and then to almost $9 trillion. The Fed stated that the growth would “support the flow of credit to households and businesses” by putting more money in the hands of lenders. Those crises have now passed, and credit to households and businesses is flowing normally. Yet the Fed is still maintaining an inflated balance sheet. Who is benefiting from the extra market funding provided by the Fed, if there is less contemporary benefit to today’s households and businesses?

When the Fed grows its balance sheet through the purchase of assets (mostly Treasury securities and mortgage-backed securities) it puts money in the hands of banks and other financial institutions. Much of that is lent out in short-term funding markets, which are used by financial institutions, including banks, to fund everything from day-to-day operations to lending to trading and derivatives. So, when the Fed grows its balance sheet, there is more money available in financial markets to borrow and vice versa. In periods of stress, this extra Fed-provided funding provides security to lenders to continue the “flow” of credit.

The Fed’s balance sheet, therefore, is consequential to the economy, financial markets, and financial stability. Despite this importance, it usually receives almost no public attention. However, recent signs of stress in short term funding markets have gotten attention from the Financial Times and Wall Street Journal, and that stress caused the Fed to halt the shrinking of its balance sheet in its last meeting. Stress in short term funding markets can be an indication that the Fed has taken too much funding away. But from whom and for what purposes? The balance sheet remains too inflated to suggest that short term funding market stress is in large part attributable to the needs of the real economy. The current balance is $6.6 trillion – 60% larger than it was at the start of 2020.

Looking at the data, hedge funds are a borrowing juggernaut in short term funding markets whose borrowing is growing tremendously. The most recent data from the Office of Financial Research shows that hedge funds are borrowing $3.1 trillion in short-term funding, up from $1.3 trillion at the start of 2020. And broker-dealers, which use short-term funding to facilitate all sorts of financial trades, are borrowing $2.7 trillion, up from $1.8 trillion in 2020.

Whenever there is an increase of funding in markets, increases in short-term borrowing show that the markets will put it to work for other much more profitable activities, like trading and derivatives. This is especially true if the funding remains available for extended periods and is no longer needed to support the flow of credit to the real economy. These financial institutions are making or facilitating highly profitable trades. They don’t want to lose access to this steady stream of Fed-provided funds. Fed attempts to withdraw this funding consistently provoke stress in short term funding markets.

These dynamics are playing out now. As in past episodes, the Fed is obliging financial institutions by holding its current inflated balance sheet level, creating a “new normal” even though the increased level is no longer materially supporting households and businesses. In short, the Fed’s huge balance sheet isn’t supporting the flow of credit to the real economy the way it was. But it is providing funds for highly profitable activities in the financial markets.

In 2017 when the Fed last reduced its balance sheet, then-Fed Chair Janet Yellen said the reduction would be “like watching paint dry.” Powell shared this sentiment in 2022 when it most recently kicked off a round of reduction, stating that it would be done in a “predictable manner” that wouldn’t “have any macroeconomic significance over time.” Instead, considering the size and impact of its balance sheet, the Fed must be more transparent about its goals and actions. This would hold the Fed accountable for its actions with its balance sheet as much as its actions on policy interest rates. Transparency would also draw a line between how its actions are helping the real economy compared to financial markets. The American people deserve as much.

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