In an effort to stimulate the economy in the aftermath of the Great Recession, the Fed cut its benchmark interest rate to zero and began buying up government and mortgage-backed securities to drive down interest rates further. The Fed stopped adding to its balance sheet in 2014 and it now stands at more than $4.4 trillion, compared with around $850 billion before the crisis.
But because the economy has grown and the financial world has changed so much since then, officials say there is no going back to the old level. More likely, these officials say, the Fed will aim for a balance sheet size of $2.5 trillion, or a reduction over several years of about $2 trillion.
A bigger Fed balance sheet on a more permanent basis is potentially good news for long-term interest rates. It means the Fed will have fewer bonds to unload, and so exert less upward pressure on interest rates. But if the Fed's calculations are wrong, it could mean higher inflation and higher rates.
The biggest reason why there's no going back to the old balance sheet is currency. For a variety of reasons, the amount of currency in circulation has grown 7 percent a year on average over the past five years, or 3 percentage points faster than in the five years before the crisis. People are simply expressing a desire to hold more cash — ironic in a financial world that is growing more digital — and the central bank's job is to simply meet that desire for cash passively.
About $1.5 trillion of cash is currently in circulation and, if current growth rates continue, that level will be north of $2 trillion in the next five years, providing a floor for just how small the balance sheet can get.
Other factors will combine to keep it large. Unlike before the crisis, the Treasury now keeps most of its money on account at the Fed. At the end of 2007, the Treasury kept just $4.5 billion at the Fed; by the end of 2016, it was $374 billion. Most banking experts think this is a good idea. Commercial banks, which used to service the Treasury's general account, are now subject to capital and liquidity requirements that make holding the Treasury account too costly. The Fed doesn't have to follow those rules.
The same is true for foreign central banks, which hold an additional $250 billion on account at the Fed. Both Treasury and foreign central bank deposits are essentially considered "hot money," meaning it can be quickly withdrawn, threatening liquidity at commercial banks. So experts think it should be on account at the Fed.
Add all three major sources together — currency and Treasury and foreign central bank deposits — and the minimum size of the balance sheet is already easily at $2.5 trillion.
And some argue it should be bigger still.