The Evolving Role of the Fed’s Balance Sheet: Effects and Challenges

Abstract

Chaitri Gulati is an assistant economist at the Federal Reserve Bank of Kansas City. A. Lee Smith is a vice president and economist at the bank. This article is on the bank’s website at www.KansasCityFed.org The Federal Reserve’s balance sheet more than doubled to nearly $9 trillion in the wake of the COVID-19 pandemic, primarily due to large-scale asset purchases (LSAPs). Although the Federal Open Market Committee (FOMC) had previously employed LSAPs during the global financial crisis, the pace of asset purchases in March 2020 was unprecedented, as the FOMC sought to relieve severe strains in financial markets that threatened to halt the flow of credit to households and businesses. The Federal Reserve continued to purchase assets at a reduced pace through March 2022 to support the economic recovery. More recently, with inflation surging and the labor market tight, the FOMC has started to withdraw policy accommodation and has set in motion a plan to significantly reduce the balance sheet. However, the process of balance sheet reduction is likely to be challenging, as policymakers have much less experience with adjusting the balance sheet compared with their primary policy instrument, the federal funds rate. Indeed, they have engaged in quantitative tightening (QT), or balance sheet reduction, only once before. Moreover, it is not clear exactly how much accommodation the pandemic-era asset purchases have put in place, making it difficult for policymakers to judge how fast and how far to unwind them.