The Federal Reserve plans to reduce its balance sheet. Here’s what that means.

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The Federal Reserve is expected to raise its benchmark interest rate by half a percentage point on Wednesday. At the Fed’s last press conference in March, Chairman Jerome Powell noted that in addition to rate hikes, the central bank has another tool it plans to use to fight the crisis. inflation.

“There’s also the shrinking balance sheet,” Powell said. “People do the math in different ways, but this could be the equivalent of another rate hike.”

In an environment of high inflation and rising interest rates, we asked Cathy Zhang, professor of economics at Purdue University, to help us break down the balance sheet.

What is the Fed’s record?

“The Fed’s balance sheet is going to be a financial statement that’s actually updated weekly,” Zhang said. “It shows what the US central bank owns and owes.”

On the asset side of its balance sheet, a household may own stocks, bonds or a house. Federal Reserve assets include Treasury debt and mortgage-backed securities. Like a household’s loans or mortgages, the Fed’s balance sheet also includes liabilities: US paper money and money that commercial banks hold in accounts at the Fed. According to its latest update released on Thursday, the central bank’s balance sheet is just under $9 trillion.

Why is the balance sheet an important policy tool?

To understand the role of the balance sheet in monetary policy, we need to go back to the Great Recession, Zhang said. Under President Ben Bernanke, the Federal Reserve cut rates to the 0-0.25% range by the end of 2008, from 5.25% in September 2007, before the recession.

“You can only reduce interest rates to a certain extent,” Zhang said. “So once you hit zero, you’re at a lower limit. And that wasn’t enough to stimulate the economy, and what the Fed did was it turned to less conventional tools.

The Fed began using the balance sheet to pump money into the economy for the first time.

“He started buying a lot of long-term Treasury bills and federal agency debt as well as mortgage-backed securities,” Zhang said. “The idea was to … increase the availability of credit.”

The Fed’s balance sheet has grown from less than $1 trillion before the Great Recession to $4.5 trillion in 2015. By purchasing these assets and increasing the availability of credit, the Fed has helped ensure that businesses can take out loans to grow, hire and retain workers, and that also kept mortgage rates low.

What are the risks of balance sheet contraction?

In 2017, the Federal Reserve began the process of reducing its balance sheet after the Great Recession. But after about two years, volatility in the money markets prompted the central bank to halt the contraction process.

Now the Federal Reserve will start shrinking the balance sheet again, for only the second time. This time, its balance sheet is worth trillions more than it was after the Great Recession.

“With even the levels of this current balance sheet, these will be big market moves,” Zhang said. She is waiting for the Fed to release a timetable showing how and when it will reduce the assets it has purchased during the pandemic.

“I’m a little worried about the effects on the financial markets,” she said. “Whether it’s a temporary shock or a more lasting shock will very much depend on their announced timeline.”

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