According to Federal Reserve economists, after halting the reduction of its $6.5 trillion asset portfolio, the Fed must confront the question of what level its balance sheet should be maintained at. Researchers Burcu Duygan-Bump and R. Jay Kahn wrote in a paper published Wednesday that determining the optimal size of the Fed's balance sheet involves trade-offs between a smaller size, low interest rate volatility, and limited market intervention. The researchers wrote, "The Fed faces a 'balance sheet impossible trinity' because they can only achieve two of these three goals at any one time. The underlying tension between these objectives stems from the financial sector's demand for reserves and the frequency of sudden changes in liquidity supply and demand."
In December, as signs grew that bank reserves were no longer abundant and signals of stress in the $12.6 trillion short-term money market intensified, the Fed ended a balance sheet reduction campaign that had lasted over three years. Driven by a series of large-scale asset purchase programs in the context of the 2008 global financial crisis and the COVID-19 pandemic, the Fed's balance sheet ballooned from just $800 billion nearly two decades ago to a peak of $8.9 trillion in June 2022.
Central bank officials appear divided on how low bank reserves can be reduced to return the balance sheet to pre-crisis levels. Fed Vice Chair for Supervision Michelle Bowman has advocated that the Fed should seek to achieve the smallest possible balance sheet size. In 2019, the Fed decided to shift to a so-called "ample reserves" regime by holding a large quantity of Treasury securities. As part of the current operating system, the Fed pays interest on reserves deposited by banks and on cash temporarily placed with it by money market funds.
Last month, as money market rates remained elevated ahead of year-end pressures, the Fed announced it would begin "reserve management purchases" to keep its stock of reserves at an ample level. The Fed economists wrote, "This 'impossible trinity' highlights that central banks must decide to what extent they will absorb liquidity changes through the size of their balance sheet, manage them through frequent market interventions, or allow them to cause interest rate volatility."
They stated that regardless of the choice made, "the central bank will almost always leave a footprint," whether that imprint is made through its asset holdings or via market operations. A large balance sheet increases the central bank's structural influence in financial markets, creating a buffer of safe and liquid assets that prevents short-term rate volatility without requiring regular Fed intervention.
The authors wrote that operating with fewer reserves increases volatility in money markets, forcing market participants to adapt to liquidity pressures. However, this could also weaken the Fed's control over interest rates, complicating the transmission of monetary policy, especially during unexpected shocks. Policymakers could also choose to tolerate a certain degree of interest rate volatility at certain times, such as quarter-end reporting dates, and address it with additional market operations and a slightly larger balance sheet size.
However, the authors noted that frequent use of the Fed's tools could distort market signals, a concern similar to that associated with a large balance sheet. The authors wrote that the appropriate steady-state size of the balance sheet "remains an open question, as economists or policymakers have not yet reached a consensus on the issue."
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