Just like any other business, The Federal Reserve keeps a balance sheet to show its liabilities and assets. Unlike the other ordinary banks, its assets are loans it extends to financial institutions and securities bought in the market. Its liabilities are the currency that is circulating and the bank reserves that are in commercial banks. During an economic crisis, it can buy more assets to expand its balance sheet. For many years, the fed watchers and economists have predicted economic cycle changes by relying on liabilities and assets movements. To increase the country’s economy, the central bank uses a quantitative easing (QE) policy, where it buys government bonds and other financial assets.
In 2008, the central bank started experimenting with the QE policy by injecting the economy with new funds by acquiring large quantities of long-term assets, like treasury bonds. It was successful in terms of moderating the 2008 crisis fallout. In 2009, the fed had an asset value of $2.3 and ran its first QE program from the beginning of 2009 till August 2010 (QE1). The $1.25 trillion purchase in Mortgage-backed securities is the most notable event of this program. QE2 program began in November 2010 and ran till June 2011. It included the $600B purchase in long-term Treasury bonds. The Fed’s asset value was $2.9m trillion.
The Federal Reserve started purchasing mortgage-backed securities in September 2012 at a 40B per month rate. It was supplemented in January 2013 with the acquisition of the long-term kind of Treasury securities at a $45B per month rate. This marked QE3 and the Fed’s asset value was $4.5 trillion. However, both these programs were ended in October 2014. In October 2017, the Fed started to wind down the balance sheet with a 10B per month initial rate and increased it in every quarter until it reached 50b per month. At this point, it had an asset value of $3.7 trillion. In October 2019, it began buying treasury bills at $60B per month to solve liquidity issues that would happen in the overnight lending markets. It marked QE4, and the Fed’s asset value was $6 trillion. In 2020, after the onset of COVID-19 in the U.S., the Fed has injected the economy with $1.5 trillion.
These changes occurred because the Fed has the responsibility to influence the pace at which the economy grows via adjusting its federal fund’s rate. It determines the amount that banks can lend and borrow each other overnight. The rates became cheaper because the cheaper borrowing gave businesses and consumers an incentive to invest and spend money, thus pushing economic growth. The securities the Fed bought were used as a benchmark for long-term borrowing. The changes imply that bank deposits and reserves will keep growing as has been the case since 2009 with the Fed’s increase in its balance sheet. If any bank attempts to reduce its balance sheet by turning away business or household deposits, the money will flow elsewhere around the banking system. The changes also imply the private sector now holds more deposits and cash than before. Lastly, it means that the private sector is getting the ability to react to Fed’s increase in deposit and cash holdings by seeking alternative riskier high yielding assets.
During financial crises, Federal Reserve can monitor policy implications by calling financial institutions to keep a certain amount in their reserve account. It should also control its federal funds’ rate because it is the base used by other financial institutions in the prices charged to its customers hence affecting business operations in the country. A low federal rate is useful during inflation, and the Fed should engage in the open market operations and set the requirements of the reserve. During inflation, the Fed should purchase more government securities because it will increase money circulation and normalize the banking system’s functioning. It can also change the bank’s reserve requirements by decreasing them and giving them more massive amounts of loans. It will lead to higher inflation because of the increased money supply and low federal funds rate.
Over the years, quantitative easing has raised some concerns. The most severe danger has been inflation, which has always been a result of any unplanned expansion of the bank reserves. The combination of a dearth of safe investments and reserve interest payments has led banks to accrue large amounts of excess reserves. It has prevented the monetary base expansion from getting into the spending stream as excess money supply form. It is a process that cannot be carried on forever. Soon the dropping rates will not be enough to keep the bank’s reserves. It could happen if yields on an alternative asset arise because of the widening recovery. It is unless the Treasury is prepared to bear rising costs or Federal Reserve decides to raise its interest rate. Reselling to the banks the assets that were purchased by the Fed won’t do the trick since most of them will be bought at a significant discount in comparison to what Fed paid for.