The Fed's $6.5 Trillion Balance Sheet Trilemma

The Federal Reserve has stopped shrinking its massive $6.5 trillion portfolio, sparking a critical debate over its ideal size. According to the central bank's own economists, this decision involves a fundamental trade-off that pits competing policy goals against each other.

In a recent paper, Fed researchers Burcu Duygan-Bump and R. Jay Kahn argue that central banks face a "balance sheet trilemma." This framework highlights the tension between the financial sector's demand for reserves and sudden shifts in market liquidity.

Understanding the Core Conflict

The trilemma suggests that a central bank can successfully achieve only two of the following three objectives at any given time:

• A small balance sheet

• Low interest-rate volatility

• Limited market intervention

The Fed’s decision to halt its balance sheet reduction in December followed a three-year effort. The move came after stress signals emerged in the $12.6 trillion short-term money markets, indicating that bank reserves were no longer abundant.

To manage these pressures, the Fed announced last month it would begin reserve management purchases to ensure its stock of reserves remains at an ample level while money market rates are elevated.

A Balance Sheet Swelled by Crisis

The Fed's current portfolio is a legacy of its responses to major economic shocks. Its balance sheet expanded from just $800 billion nearly two decades ago to a peak of $8.9 trillion in June 2022. This growth was driven by large-scale asset purchase programs launched during the 2008 global financial crisis and the COVID-19 pandemic.

Since 2019, the central bank has operated under an "ample-reserves regime," holding a large portfolio of Treasuries. Under this system, it pays interest on reserves that banks park with it and on cash that money market funds place at the Fed.

However, officials remain divided on the long-term strategy. Fed Vice Chair for Supervision Michelle Bowman, for instance, has advocated for shrinking the balance sheet as much as possible to return it closer to pre-crisis levels.

Three Competing Policy Paths

The trilemma forces policymakers to choose a strategy, with each option carrying significant consequences for financial markets.

Path 1: Maintain a Large Balance Sheet

A large balance sheet can act as a structural cushion, providing safe and liquid assets that prevent short-term rate volatility. This approach reduces the need for the Fed to conduct regular market interventions. The downside is a large and permanent central bank footprint in financial markets.

Path 2: Operate with Leaner Reserves

Shrinking the balance sheet would increase volatility in money markets, forcing participants to adapt to liquidity pressures on their own. However, the authors of the paper warn this could weaken the Fed's control over interest rates and complicate the transmission of monetary policy, particularly during an unexpected shock.

Path 3: A Hybrid Approach

Policymakers could also choose a middle path, tolerating some rate volatility around predictable events like quarter-end reporting dates. In this scenario, the Fed would respond with targeted market operations and maintain a slightly larger balance sheet. The risk, however, is that frequent interventions could distort market signals, creating problems similar to those associated with a permanently large balance sheet.

An Unresolved Question for the Fed

Ultimately, the choice of strategy will define the Fed's role in the market. As the economists noted, regardless of the path chosen, "the central bank will almost always have a footprint," either through its holdings or its market operations.

The appropriate long-term size of the balance sheet remains an open question, with no clear consensus among economists or policymakers.