The Federal Reserve's Balance Sheet: What You Need to Know

Christian Peterson Apr 10, 2019
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The Federal Reserve Bank wields enormous influence on our economy. Its primary job is to keep the value of the U.S. dollar as stable as possible. It does that by controlling short term interest rate and providing what's known in financial circles as "liquidity." This story explains how the Fed uses its balance sheet to meet these goals.

The Federal Open Market Committee

The FOMC meets eight times a year. At these meetings the board members debate and set monetary policy. They may choose to raise or lower the Fed Funds Rate, the Discount Rate, or the reserve requirements for member banks.

The reserves that member banks are required to keep at the Federal Reserve make up the Fed's Balance Sheet.
Banks are allowed to loan out a "multiple" of their reserves. The multiple is usually around 10 to 1, which means that, if a bank has one million dollars in reserve, can loan out 10 million dollars. This is called "fractional banking."

It is how wealth is created and how the financial system is able to adjust to meet the needs of a growing economy.
All markets, whether it's the stock market, housing market, labor market or a flea market, work on the concept of "liquidity."

Liquidity describes the degree to which something can be quickly bought or sold without affecting the asset's price.

The market for canned beans is very liquid. Millions are bought and sold everyday and the price remains stable.
The Federal Reserve can increase or decrease the overall liquidity within the U.S. economy by changing the amount of reserves in the financial system.

The more reserves, the more lending that can take place. The more lending available, the greater the liquidity in the financial system.
A little bit about the Fed, who owns it? Who runs it?

The Federal Reserve is the "central" bank. It is the bank that other banks use.
The Federal Reserve Bank is not part of the Federal Government. It is a privately held corporation. Stock is held by the member banks.

However, holding this stock does not carry with it the control and financial interest given to holders of common stock in for-profit organizations. The stock may not be sold or pledged as collateral for loans. 
Although a privately held company, Congress and the President appoint the Board of Governors, who decide Fed policy.

This was a compromise worked out by President Woodrow Wilson and the banking interests when the Fed was created in 1913.

It is important that the banking system be independent of politics, yet the bank serves the public interest.

The Balance Sheet

The Federal Reserve does not print money. Only the Department of the Treasury prints money. What the Fed does is create Liquidity.

This is kind of tricky because Liquidity is not something you can hold in your hand, like a dollar bill. Liquidity is a condition. It is a capacity.
The Fed creates (or extinguishes, if it thinks it's necessary) Liquidity by manipulating its balance sheet. The Fed can create its own cache of reserves and make them available to the banking system so banks have more capacity to lend money.
But,it cannot create this cache of reserves out of nothing. The accounts have to balance.

When we talk about a "balance sheet", we are talking about credits and debits - assets and liabilities. The "reserves" at the Federal Reserve Bank are liabilities. They are something the Fed owes.
This seems counter-intuitive. You would think those reserves would be an asset, but they're not. Not to the Fed. They are an asset to the bank that actually owns the reserves.

The Fed is holding the reserves on the bank's behalf. Hence, they are a liability. These liabilities are the essential ingredient that creates banking Liquidity.
So what the Fed wants to do is to create more liquidity in the financial system. It can do that by piling up more reserves. 

If a regional bank can lend $10 million with $1 million at the Central Reserve Bank, then it can lend $19 million if it has $2 million at the Central Reserve Bank. 

More reserves, more liquidity.
How does the Fed create more reserves? Reserves are liabilities, so we can ask the same question a different way.

How does the Fred create more liabilities on its balance sheet? It can only do that by acquiring an equal number of assets. So, where does it get the assets?
It gets its assets from someone else's liabilities. When you deposit money at the bank, that money is an asset to you, but it is a liability to the bank.

Conversely, when you borrow money from the bank, that loan is a liability to you but it's an asset to the bank.
The U.S. government borrows a lot of money, it means that the U.S. has created a lot of liabilities that can be bought and sold.

And, although there are many who think that, all that borrowing has made U.S. Treasury bonds more risky, they're still considered about the safest investment in the world. So, they make a great liability to use as an asset.

And, here is where things get kind of tricky. But if you like this kind of thing, and can do the mental gymnastics necessary to trace how an asset flips over and becomes a liability and how a liability covers an asset, then follow along. It's really not that hard.
We're trying to figure out how the Federal Reserve Bank uses its balance sheet to create (just enough, but not too much) liquidity in the banking system, so that prices remain stable, and there is enough credit available so that businesses can prosper and people can get a good loan to buy a house. Or whatever else they want...
  • The Fed wants to create liquidity by boosting the reserves in the Federal Reserve system. 
  • The reserves are a liability to the Fed, so it has to acquire assets to offset the liabilities. 
  • Loans are an asset to the member banks in the Federal Reserve system. 
  • So the Fed want's to get its hands on those loans. 
  • The best loans to get are U.S. Government bonds.
Let's take an example of a big Wall Street bank like Goldman Sachs. And let's say that Goldman Sachs has a million dollars of U.S. government bonds.

These bonds are an asset to Goldman Sachs, because the U.S. borrowed money and has to pay it back.
So, the Federal Reserve comes along and says, "How about you give me those bonds and, in return, I'll credit you a million dollars in your reserve at the Federal Reserve Bank?'

Goldman likes the idea because, by giving up one million dollars in assets, it now has the ability to loan out 10 million more dollars and collect interest on those loans.
Now, what the Fed did here is a little like Alchemy. You know those guys who used to turn lead into Gold? Kind of like that. It took a million dollar asset from Goldman Sachs and in return gave it...

Well, it really didn't "give" it anything. Not anything real, anyway. What it did was credit Goldman's reserve account, at the Fed, one million dollars.
So, what the Fed did was move the asset from Goldman's balance sheet to its own, and created a liability to offset the asset so its own balance sheet would "balance."

Goldman Sachs received an asset (which is the credit to its reserve account) for an asset. And the U.S. economy has about $10 million more in Liquidity to finance new growth and innovation.
If inflation is running too high, the Federal Reserve can reverse this process.

It can off load the bonds it is holding (basically, put the bonds back on the member bank's balance sheet) and when those assets are off the books, it will un-credit the bank's reserves at the Fed - thus making credit and liquidity less available.
It is the Fed's ability to create liabilities out of thin air that makes this alchemy possible. Note, though, that it doesn't create assets out of thin air.
 
That would be like printing money. That would be like creating a car, a boat, or a house out of nothing. You can't do that - and the Fed doesn't try. The Fed is creating an obligation.
And the laws of finance allow anybody to assume an obligation.  
"Hey, I'll come over tomorrow and fix your sink."

There, you've just created a liability. It cost nothing and assumed nothing. Perfectly legit. Everything will work out fine so long as all the obligations will be met.
Our economy is a vast and infinitely complex chain of obligations. The Fed's role is to manage those obligations with a flexible credit system that can expand and contract as conditions warrant.

The system will work so long as all the obligations can be met... and therein lies the rub.
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