The Mechanics of Fed Balance Sheet Normalization

The focus of the article — the process of current reduction of the Fed’s holdings of securities after the great expansion of its the balance sheet in 2020–2021 in response to the pandemic COVID-19. The large-scale asset purchases of central bank helped to stabilize the fi nancial markets and support the economy, but at the beginning of 2022 it became clear that the economy fully recovered from the pandemic recession and it’s time to drain excess liquidity from the banking system. This called from Fed for actions termed "balance sheet normalization" or "quantitative tightening" (QT), aimed to reduce the size of the Federal Reserve’s balance sheet and bank reserves to an optimal level. But the optimal level of reserves is conceptually murky and is diffi cult to estimate. It only means that Fed should hold enough securities so that shocks do not push reserves below some minimum level of ample reserves, which is uncertain. In this paper we discuss risks of the accelerated pace of reducing the size of the Federal Reserve balance sheet that could induce reserve scarcity and new fi nancial stress. We consider the key metrics, that Fed uses to determine whether the reserves are still ample and when normalization should end. The paper shows the importance of taking into account the experience of previous normalization, monitoring behavior of key players that aff ect the level or reserve balances and dynamics of money market interest rates. We consider the factors impacting demand for liquidity from banks and nonbanks. We point out that effects of QT (opposite to quantitative easing) are less studied and still it is not clear how this policy affects economy and inflation.