Waller: Fed's balance sheet can't go back to pre-pandemic size

Bloomberg News

Federal Reserve Governor Christopher Waller said changes are coming to the central bank's balance sheet, but don't expect the expanded holdings to return to pre-pandemic levels.

During a question and answer session on Wednesday at an event hosted by the University of California, Santa Barbara, Waller said the Fed wants to reduce its holdings, but noted that the annual growth of the money supply limits how much reduction can take place.

"Our balance sheet grows about 7% a year from printing currency, issuing it off and … most of it goes outside the U.S.," Waller said. "So, as our liabilities grow by 7%, our assets have to grow by 7%. So, we can't even go back to where we were pre-pandemic because there's been growth of roughly 7% for the last so many years."

The Fed's balance sheet totals more than $8.4 trillion, down more than $500 billion from its spring 2022 peak but more than double the level it was at before March 2020. 

The Fed has been actively shrinking its holdings since last summer — allowing assets to expire without replacing them — as means for tightening monetary policy. Those efforts were disrupted, temporarily, amid a surge in emergency borrowing from the Fed in March after the failures of Silicon Valley Bank and Signature Bank, but they now appear to be on track.

Previously, Waller has said the Fed could stand to reduce its assets by $2 trillion without disrupting the banking system, noting that the Fed's overnight reverse repurchase program has loaned out more than $2 trillion of securities nightly since last spring. The fact that those funds are ending up in the facility, he said, is proof that banks do not need them.

Along with reserves, currency and the overnight repo facility, the Fed's liabilities include the Treasury's general account — which is being drained to pay down debts amid the ongoing debt-ceiling debate — and a repo facility for other central banks. Assets include Treasuries, mortgage-backed securities and lending and credit facilities.

How much the balance sheet could – or should — shrink beyond $2 trillion remains an open question, Waller said. Ultimately, the Fed's main concern is maintaining an "ample supply" of reserves, or cash available to banks, in the system because when reserves become scarce, banks compete for them and drive up prices, thus disrupting the Fed's ability to set borrowing costs.

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Waller said the Fed's balance sheet is currently about 30% of gross domestic product, up from the mid-teens rate seen before the pandemic and about 7% before the subprime mortgage crisis. But, he said, there is no consensus view about what the appropriate ratio of balance sheet-to-GDP is.

"There is no economic theory that tells you how large a central bank's balance sheet should be, there's no theory about it at all," he said during the event. "We've got some central banks — Switzerland — their central bank balance sheet is 100% or more of GDP."

Waller noted that along with the winddown of the balance sheet, which is seeing about $95 billion of assets roll off each month, the Fed is considering some other changes to the composition of its balance sheet moving forward.

He said the Fed is looking to shift to shorter-dated securities, abandoning a post-2008 policy change toward long-dated assets made to drive down long-term interest rates. While that strategy was effective, Waller said, the end result was the Fed having to hold onto assets for longer than it had historically. 

"The problem with long-duration assets is they're long duration, once they're on your balance sheet, you've got them for a long time," he said. "Over time, we're going to try to bring that maturity structure back down."

He also noted that he'd like to see the Fed move away from purchasing mortgage-backed securities entirely because of their 30-year maturity.

"I don't really like that we have that asset, it's a little too much concern for me," he said. "But, hopefully, we, at some point, can kind of run those off and never get into the business of buying mortgage-backed securities again."