September 4, 2019

The Federal Reserve’s balance sheet reflects the extent to which the Fed bought securities to support the economy since late 2008.  Prior to the recession, the Fed’s asset holdings were about $900 billion.  But then when the bottom dropped out, Lehman Brothers collapsed and the banking sector was on the verge of imploding, the Fed bought all sorts of securities in an effort to provide sufficient liquidity to the banking system to prevent a complete collapse of the financial sector.  Its balance sheet exploded from $900 billion to about $4.5 trillion.

Its balance sheet quickly rose from $900 billion in September 2008 to $2.2 trillion by the end of that year.

From the end of  2008 through the end of 2010 the Fed’s balance sheet then stayed relatively steady.  But at the end of 2010 the Fed decided that it was unhappy with the unemployment rate at almost 10% and it engaged in a second round of easing which as become known as QE2 (or Quantitative Easing 2).  They decided to purchase another $600 billion of securities which boosted its balance sheet to $2.8 trillion in an effort to push long-term interest rates lower, provide additional stimulus to the economy, and  (hopefully) push the unemployment rate sharply lower.

The third step in Fed easing occurred in September 2011.  They decided to sell $600 billion of Treasury bills and short-dated Treasury notes, and buy an equivalent amount of long-dated Treasuries.  By doing this “swap” the Fed did not further inflate its balance sheet.  The object was to push long rates lower and, hopefully, provide further stimulus to the housing market.  As a result the yield on the 10-year note fell to a record low level of 1.5% by the summer of 2012.

The fourth step in the Fed easing process came in September 2012 when the Fed indicated that it was not happy with the 8.1% level of the unemployment rate and wanted it to decline more quickly.  So to jump start the economy, the housing market in particular, it told us that it intended to buy $40 billion of mortgage-backed securities every month until such time as the unemployment rate declined to a more acceptable level.  That was in addition to its monthly purchases of $45 billion of Treasury securities.  That means that the Fed further increased the size of its balance sheet which has climbed from $2.8 trillion in September 2012 to its current size of to $4.5 trillion.

But the economy eventually progressed to the point where the Fed felt comfortable phasing out its monthly purchases of securities.  Indeed, it began to gradually trim its pace of buying securities from $85 billion per month ($45 billion of U.S. Treasuries and $40 billion of mortgages) at its peak in December 2013.  It cut its purchases by $10 billion at each FOMC meeting during 2014 and eliminated the program entirely by October of 2014.   Its portfolio then remained essentially unchanged for the past three years.  It consists of $2.1 trillion of U.S. Treasury securities, $1.5 trillion of mortgages, and $0.2 trillion of agencies, gold,  and other securities.

The Fed knows that it must shrink its portfolio to a more “normal” size.  It has said that it does not plan to sell securities outright to reduce the size of its balance sheet, but it does intend to gradually shrink its portfolio by allowing maturing securities to mature.  It started out slowly by reducing its portfolio $10 billion per month in the fourth quarter of 2017.  It then reduced it by $20 per month in the first quarter of 2018, $30 per month in the second quarter, $40 billion in the third quarter, and $50 billion in the fourth quarter.

However, in January 2019 it said that it plans to conclude the reduction in its holdings of securities at the end of September 2019.  That would leave its aggregate security holdings to stabilize at about $3.7 billion which is somewhat higher than required to efficiently implement monetary policy.  By so doing it clearly wants to avoid its policy from inadvertently becoming “too tight” and possibly causing the economy to slip into a premature recession.

.Stephen Slifer


Charleston, SC