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How the Fed is using its multi-trillion-dollar balance sheet to fight inflation

today 10/29/2023
The Federal Reserve's efforts to combat inflation will soon enter a new phase, but its large balance sheet will continue to be important. The Fed has been raising interest rates aggressively to control inflation and maximize employment, which are its main responsibilities mandated by Congress. However, the central bank has other tools at its disposal, including managing a multi-trillion-dollar balance sheet that includes government securities and currency in circulation. The Fed's balance sheet can also be used to strengthen or weaken the economy. Although it seems that the Fed may be done raising interest rates, with the possibility of one more hike in December, the economy is still growing strongly, the job market is tight, and inflation remains above the target. This means that the Fed still has work to do to cool the economy, and the balance sheet will continue to play a role in doing so. The Fed's balance sheet consists of assets like Treasuries, mortgage-backed securities, and loans to banks, as well as liabilities like currency and bank reserves. When the Fed wants to stimulate the economy, it expands its securities holdings through quantitative easing. Conversely, in recent years, the Fed has been reducing its balance sheet to cool the economy, a process known as quantitative tightening. The Fed's balance sheet currently stands at around $7.9 trillion, down from its peak of $9 trillion. Economists at Wells Fargo expect a recession next year to prompt the Fed to stop quantitative tightening by October 2024, leaving the balance sheet at around $7.2 trillion. However, there are alternative scenarios for the end of the balance sheet runoff if there is no recession. The Fed's main tool for influencing the economy is the federal funds rate, which it adjusts at its scheduled meetings. Raising the rate helps control inflation, while lowering it supports economic growth. The Fed can also leave the rate unchanged if more data is needed or if the economy is trending positively. Manipulating the federal funds rate has a significant impact on credit accessibility and is the Fed's most well-known method of influencing the economy.
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