In 2007, the Federal Reserve had a balance sheet of $900 billion. Then the economic crash of 2008 hit. As a result of quantitative easing and other steps to mitigate the disaster, that sheet has become five times bigger over the last eight years, and currently sits at around $4.5 trillion. Many would recommend trying to decrease it again, now that the economy is becoming more stable. However, former Fed chairman Ben Bernanke disagrees.
A Change in the System
The shift over the last four years represents not only a growth of the Fed’s balance sheet, but a significant change in their entire system of influencing interest rates. The pre-2008 method used a smaller sheet to manage the funds that vary the supply of bank reserves. Now, by making it much bigger, they’ve also enacted a new policy, the Interest Rate on Excess Reserves (IoER).
Current Fed Chair Janet Yellen has expressed a desire to return gradually to the original system and smaller balance sheet, and believes it to be more reflective of stable economic times. However, Bernanke believes that keeping the sheet at or near its current level is the best thing for our economy in the long run.
Promoting Financial Stability
Bernanke isn’t alone. Several experts have suggest keeping the balance sheet large could help the U.S. economy remain stable. Many companies have an increased demand for safe, liquid assets and short term securities. Leaving it to the private sector to provide these assets can have a destabilizing effect and make behavior look appealing in the short term that’s dangerous in the long run.
However, Bernanke argues, with a larger balance sheet, the Fed could provide these assets safely using bank reserves. This would discourage riskier actions while keeping businesses stable.
A larger balance sheet is also integral to the Fed’s Repurchase and Reverse Repurchase Programs. The former makes affordable loans to other institutions and the latter takes loans out from them, with the promise to repay quickly (often overnight) at a higher rate.
In doing so, they can either add or subtract money from their reserves as needed to maintain a balance. This in turn gives them a greater control over not just the interest rate, but general financial stability in the private sector. However, again, these kinds of transactions can only be made if the Fed’s balance sheet remains large.
Protecting the Future
Finally, maintaining the current system is a good idea in case another financial emergency arises. When the 2008 crash occurred, it took everyone by surprise, and the Fed had to scramble to find a solution. Now that there is one in place, it makes sense to keep things the way they are, in case they need to take similar actions in the future.
With a large balance sheet, central banks can be a last resort to provide liquid assets in times of crisis. They can loan money to institutions that need it without destabilizing the economy. Having to borrow money is often considered a sign of weakness, but in many cases, it’s the smartest move an institution can make, and can help prevent disaster. By maintaining the current system, borrowing can become less of a taboo and more of a smart and necessary business move.
Will Bernanke’s words have any impact on the current Federal Reserve Board? It’s difficult to say. He’s not in charge anymore, but his opinion is still valued by many. We’ll just have to wait and see whether Janet Yellen continues with her plan of bringing the balance sheet back down, or heeds Bernanke’s advice.