Why does the Fed feel the need to reduce its balance sheet?

What is the problem with the Fed having a large balance sheet long term? What would happen if the value on the Fed's balance sheet collapsed, say in a bond crash?

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    $\begingroup$ This website aims to avoid opinion-based answers. I see no way of answering this question without it being an opinion. There’s an infinite number of potential risks. The issue is whether they matter. $\endgroup$ – Brian Romanchuk Jun 11 '20 at 21:12
  • $\begingroup$ @BrianRomanchuk i have changed my question and made it more specific $\endgroup$ – Trajan Jun 12 '20 at 7:44
  • $\begingroup$ @BrianRomanchuk i dont think that the other risks of qe are well dealt with online $\endgroup$ – Trajan Jun 12 '20 at 13:23

Brian Romachuks answer above is an excellent answer.

Just to lay out what the opposing argument is against having a large balance sheet:

1) “by increasing the balance sheet, we create a bond bubble that is destined to pop when we start having inflation”

2) “In an ideal world (full employment, 2% inflation), the Fed would prefer to have a small balance sheet because it does not want to create economic distortions by holding government debt. The government, (or anyone for that matter), should not be given a free lunch while private enterprise has to continue paying higher interest rates. That’s unfair to private enterprise”

And here is the opposite side of that argument: Central Banks have been trying to spur inflation for over a decade now by increasing their balance sheets.

However, the opposite has occurred. Instead of inflation, there is a massive deflationary force at play as billions of people are lifted out of poverty, and are increasing their productivity. This massive increase in cheap, increasingly productive labor has resulted in sustained price deflation worldwide.

I could go further with this, but I’ll stop there because I think it’s the most direct answer to your question I can give, and it’s already opinionated enough.

Well, one more opinion. People have been worried about skyrocketing government debt for as long as I can remember, which is back to at least 1978. The real economic cost of servicing that debt hasn’t really changed that much though, because interest rates remain low.

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    $\begingroup$ I dont agree with your opinion comments. All economics is opinion based, as unlike the physical sciences you cant do repeatable experiments $\endgroup$ – Trajan Jun 14 '20 at 19:52
  • $\begingroup$ These arguments against big balance sheets are what i was looking for $\endgroup$ – Trajan Jun 14 '20 at 20:09
  • $\begingroup$ Its not clear to me where lifting people out of poverty would not cause inflation due to fighting over scarce resources $\endgroup$ – Trajan Jun 14 '20 at 20:18
  • $\begingroup$ There are very few scarce resources. The price of things like copper, natural gas, iron ore, oil, and lumber have all plummeted due to technological innovation and cheap labor. Of course there is short term scarcity of things like cobalt and lithium for batteries, but those prices will all plummet in the near future as people invest money to develop new sources. $\endgroup$ – Keith Knauber Jun 14 '20 at 20:33
  • $\begingroup$ 20 years ago people were saying things like “we’re going to run out of oil”, or “there’s not enough rare earth metals to go around”. All of this turned out to be untrue. There’s plenty available, and the cost of obtaining them from new sources has plummeted. $\endgroup$ – Keith Knauber Jun 14 '20 at 20:35

This is veering into the direction of an opinion-based answer, but I would argue that there is no particular evidence that the Fed “needs” to reduce the size of its balance sheet.

  • If the Fed wanted to revert to its pre-2008 mode of operations - where interest is not paid on reserves - it would be required to reduce its balance sheet so that there are no excess reserves in the system, if it wanted the Fed Funds rate to be greater than zero. In the aftermath of the Financial Crisis, many commentators assumed that this was the case. However, the pre-2008 Fed operating procedure was unusual relative to what other central banks do, and there is no “need” to revert to it. By paying interest on reserves, it can place the overnight rate wherever it wishes (with small spreads).
  • The Fed does not mark-to-market its portfolio. Market value losses on bonds does not present an issue, as they can hold to maturity. The only “risk” is that the cost of reserves is higher than coupons received. However, like all central banks, it can operate with negative equity. At most, negative equity is a political embarrassment.
  • Are there economic effects of a large balance sheet that need to be undone? This is a disputed area of research. My opinion is that the side arguing that the size of the balance sheet matters have not presented strong evidence of this claim. One would need to look at claims about the effects of the balance sheet growth, then see whether they hold up. From what I saw of the post-Crisis literature, the effects were not clear-cut.
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    $\begingroup$ I dont agree with your opinion comments. All economics is somewhat opinion based, as unlike the physical sciences you cant do repeatable experiments $\endgroup$ – Trajan Jun 14 '20 at 19:58

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