Shrinking The Fed's Balance Sheet

There's a lot of fear around the ability of the Federal Reserve to shrink its balance sheet so to avoid inflation. Obviously, such a move can't make much progress until the economy has shown tangible signs that recovery is well underway. In response to the financial crisis, the Fed's balance sheet has grown incredibly. Although this observation isn't news, I think its size in relation to GDP is notable and looks rather shocking as a chart.

I got the idea to create this chart from reading the Brookings Institution's latest "How We're Doing" index. The statistic that really stood out was the change in the ratio of Fed's balance sheet to GDP. Of course, during the recession, GDP has fallen while the Fed's intervention increased. I went ahead and graphed the historical data since the end of 2007. Here's what that looks like:

Fed Balance Sheet GDP 2009-11.PNG

The ratio, which sat at 15.2% in the third quarter of 2009, was a mere 6.5% in the fourth quarter of 2007, as the recession began. That's a 136% increase.

As I said, there are two effects going on here: GDP declined and the Fed's assets have risen. But the Fed's actions account for the far greater effect. The change in GDP for first and last periods in the chart is just -0.3%. Meanwhile, the change in the Fed's balance sheet is 135%. In September, it was approaching $2.2 trillion.

This shows the steep mountain that the Fed has to climb in order to decrease its holdings. That's a lot of monetary supply to soak up, which almost certainly cannot be done in a very short amount of time without hurting the economy. It's quite a pickle, so let's hope Bernanke & Co. are up to the challenge.