The Fed Desperately Needs To Diet In The New Year

The Fed has to begin cutting the fat off its balance sheet.

Monetary economists have spent the past decade debating the pros and cons of the Fed’s “bloated $4.5 trillion balance sheet.” Does a large balance sheet make monetary policy more effective? Or should the Fed sell off its assets and return its more modest pre-QE balance sheet?

Often overlooked in this discussion is the negative impact the Fed’s large balance sheet might have on bank lending to the private sector, and hence real economic growth. Both have been sluggish since 2008. And the Fed’s $4.5 trillion balance sheet is partly to blame.

Financial systems play a critical role in driving economic growth. Arguably the most important channel through which finance contributes to growth is through “financial deepening,” or enabling a larger share of the public’s savings to be intermediated by private financial institutions.

The intuition is fairly straightforward. Private banks are far better stewards of the public’s savings than governments or central banks (if you don’t believe me, consider the shoddy track record of countries that have nationalized their banking systems). They specialize in channeling savings into profitable investments. These investments lay the foundation for sustained economic growth and development. The share of private bank-issued money to central bank-issued money, therefore, provides a reasonable estimate of the financial depth of an economy. The higher the ratio, the greater the prospects for economic growth.

Unfortunately, this ratio has declined rapidly in the United States since 2008Q4, when the Fed began expanding its balance sheet. For the decade prior, financial depth in the US averaged around 87.89 percent. Since 2008Q4, it has averaged just 76.24 percent. Although there are many factors contributing to this decline, the Fed’s policy of paying member banks interest on excess reserves is perhaps the chief culprit. Simply put: the Fed encouraged banks to hoard excess reserves rather than make loans. This has allowed the Fed to maintain its bloated balance sheet so that it can allocate credit to favored sectors of the economy without unleashing the bottled up genie of inflation.