The Fed's Balance Sheet

The Fed's balance sheet determines how much money is in circulation. When they want to put more money into the system ("print money") they BUY assets (bonds) from banks. Since they use cash to pay for the bonds, there is now more cash in the system.

When the economy goes into a recession, the Federal Reserve can stimulate the economy by injecting more money into the system. This blog entry examines how the Federal Reserve's balance sheet has changed over the last year. Before the recession began, the Fed's balance sheet had $800 billion on it. When looking at the balance sheet, one would see that $400 billion of the total was compromised of a mixture of long term T-Bonds and other safe bond investments. The other $400 billion was compromised of super-safe T-Bonds that expired every 1 to 6 months. For decades the Federal Reserve simply repurchased these short term bonds when they expired.

When the recession began, the Federal Reserve, in as safe a way as possible, began purchasing bonds directly from banks and other lending institutions. This injected cash into the system, but did not grow the Fed's balance sheet because the Fed offset the purchases of bank bonds by not repurchasing the "super-safe" short term T-Bonds. Thus, the balance sheet remained at $800 billion but added a little more liquidity and took on a little more risk.

When Lehman Brothers collapsed, and the LIBOR-OIS spread grew exponentially, the Federal Reserve decided to expand the balance sheet. This proved to be a difficult task. The Fed had a balancing act to perform: they had to inject enough cash into the system to keep the financial system afloat; but they also had to make sure the bonds they purchased along the way could be sold off easily when the recession ended (if the balance sheet remains at $2 trillion there is sure to be inflation). Chairman Bernanke was up to the task. Bernanke and the Federal Reserve found the safest bonds on the market, then from these selected bonds, they picked the ones that would would sell the fastest once they needed to be sold.

Therefore, the Fed's balance sheet, though huge today at $2 trillion dollars!, will be "drawn down" easily. Drawing the balance sheet down refers to exiting the Fed's added liquidity. Inflation will not occur from the Fed's large balance sheet because the bonds will be sold promptly by the Federal Reserve at the opportune time.

This quick, decisive action will certainly go down positively on Bernanke's resume.