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The Federal Reserve’s balance sheet sits at the center of some of the most persistent debates in monetary policy. In this week’s Grumpy Economist Weekly Rant, John Cochrane explains what the Fed actually holds, what quantitative easing changed, and why public discussion of the balance sheet often overstates both its macroeconomic effects and its policy significance.
Cochrane argues that the expansion of the Fed’s balance sheet did not, by itself, drive inflation or fundamentally alter economic outcomes. The more consequential issues, he suggests, lie in the composition of the Fed’s assets, the maturity structure of government debt, and the institutional boundary between the Federal Reserve and the Treasury.
Transcript
Hi, I’m John Cochrane, senior fellow here at the Hoover Institution, and welcome to my Grumpy Economist Weekly Rant.
This week, we’re going to talk about the balance sheet, specifically the balance sheet at the Federal Reserve. It’s much in the news. My colleague, Kevin Warsh, wants to reduce that balance sheet, and of course, everybody’s talking about it.
What in the world is the balance sheet? I can’t imagine a topic more designed to put people to sleep than the accounting at the Federal Reserve. Let me explain, hopefully keeping you awake.
The Federal Reserve is basically a giant money market fund. It holds Treasury securities as an asset, and it funds that asset by reserves from banks. Those are just bank accounts that banks hold at the Federal Reserve and that pay interest. So it takes interest from the Treasuries and pays that interest out on the bank accounts that banks hold at the Federal Reserve.
Just like if you have a money market fund, you get interest on your deposit, and that’s backed by Treasury securities.
What happened with quantitative easing? The Fed just expanded this tremendously. It bought Treasury securities from banks, among others, who were holding them, and gave them these interest-bearing reserves in return.
Is that hugely inflationary, an enormous stimulus? Well, do you think private money market funds are hugely inflationary and an enormous stimulus? Really, that’s all the Fed did. You can imagine it buying the Treasuries that private money market funds held and then funneling that money back through banks in the government money market fund. A swap of one for the other.
Not a big deal, or at least hard to see how that’s a big deal.
Did that boost the stock market? Set off an asset pricing bubble? Again, if private money market funds don’t set off asset pricing bubbles, it’s hard to see how a public money market fund makes much difference either.
Do you really care whether you hold Treasuries directly, whether you hold them through a private money market fund, or whether you hold them through the Federal Reserve? My first guess is this is like giving you two fives and a ten for every twenty-dollar bill. Not a big effect.
There is some effect. The Fed has bought long-term government bonds, not short-term government bonds, and so it has shortened the overall maturity of government debt.
What does that mean? If you buy a house and get a floating-rate mortgage, when interest rates go up, you have to pay more, and you might lose the house. If you bought a fixed-rate mortgage, your house payments are set forever. The Treasury bought more of the fixed-rate mortgage, and the Fed turned around and turned it into the floating-rate one, and now you see the effect: we’re paying close to a trillion dollars of extra interest costs on the debt.
Not so good.
They need to agree on who’s in charge of the maturity structure of the debt, and I think that should be the Treasury.
The Fed also bought mortgage-backed securities, thereby funneling money to mortgages that otherwise would have gone to other investments. Not so great.
So the composition of the balance sheet is a worthy thing to think about. But the overall idea of having interest-paying reserves that banks have lots and lots of is an excellent one. And we criticize the Fed too often, especially around the hallways of Hoover, and don’t recognize often enough this wonderful innovation.
There’s lots of liquidity, it’s free, and it doesn’t cause any inflation. The inflation that we saw was caused only by fiscal policy, and the banks are a lot safer from holding reserves rather than risky assets.
Now, people do complain. I think there’s the memory of cash. The fact that we’re issuing interest-bearing reserves makes all the difference.
People say, “Oh, we’re paying the banks not to lend money,” but the banks were holding Treasuries, not other loans, instead. We’re buying their Treasuries, not their loans. So that’s not true either.
Yes, there’s a worry that politicians might see the opportunity that the Fed should buy assets that they want it to have, but that’s a different issue than just the size of the balance sheet.
People think the Fed has propped up the prices of bonds. I’ll give you 10 or 20 basis points, but it’s hard to see how the Fed can affect bond prices forever.
The Treasury could help a lot if the Treasury would issue directly something like reserves: fixed-value, floating-rate, overnight debt, so the Fed doesn’t have to buy Treasury securities and then issue that security, which people seem to want a lot of.
Then we could reduce the balance sheet a lot, and the Treasury would take it directly.
Bottom line: it wasn’t a huge effect going up. It won’t be terrible going back down again. Don’t worry so much about the balance sheet.
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John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.