Op-Ed: I Don’t Know Why She Swallowed a Fly

Originally published by Morning Consult

Over the past 13 years, the Federal Reserve has consistently solved problems – whether they were partly or entirely of its own creation — by becoming larger and more involved in the financial system. That greater size and involvement has led in turn to still more problems, which the Fed has again sought to fix by expanding its reach into markets. This process has transformed the Fed from an efficiently scaled institution conducting policy with a small imprint on financial markets to a behemoth that is the largest borrower in both the unsecured and secured short-term funding markets. The Fed predicts that by 2023, its balance sheet will equal 39 percent of gross domestic product, up from 6 percent in mid-2007. How did we get here? Consider the problems the Fed faced and the solutions it adopted.

Problem: The Treasury Department’s account at the Fed swelled from $5 billion before the global financial crisis to $1.8 trillion in 2020, with a corresponding rise in volatility. The Treasury traditionally kept almost all its cash at commercial banks. But once the Fed started paying an above-market rate on reserves, the Treasury moved all its cash to the Fed, reducing the need for the Fed to borrow from banks, and saving taxpayers money. However, variability in the Treasury account made it difficult for the Fed to conduct monetary policy with a small balance sheet. Solution: Conduct monetary policy using a giant balance sheet so vast that swings in the Treasury account no longer matter.

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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.