Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Their Balance Sheet as a Policy Tool
Transcript
- Lucas: So when we talk about central banks, we usually talk about interest rates. But there is another tool that gets less attention, and in some ways it's just as powerful: the size of the central bank's own balance sheet. Luna: Right, the balance sheet. I feel like people hear that term and think it's just accounting noise, but it's actually a deliberate policy lever. Lucas: Exactly. And it's what we're going to drill into today. Because the Federal Reserve, the European Central Bank, the Bank of Japan — they all use their balance sheets to influence the economy, not just by setting short-term rates, but by deciding what assets they hold and how many. Luna: And the size of that balance sheet — it can get huge. I think the Fed's peaked at around nine trillion dollars in 2022, right? Lucas: That's right. And it wasn't always like that. Before the 2008 crisis, the Fed's balance sheet was under a trillion. But after the global financial crisis, and then again during the pandemic, they bought massive amounts of Treasury bonds and mortgage-backed securities to push long-term rates down and keep financial conditions loose. Luna: So it's like a second channel for policy. Instead of just changing the overnight rate, they're directly buying assets and changing their price. Lucas: Precisely. And the term for that is quantitative easing — QE. When the Fed buys a Treasury bond, it's not just sitting on the sidelines; it's creating bank reserves to pay for it. That adds liquidity to the system and pushes down yields on those bonds, which then spills over into mortgages, corporate debt, even equities. Luna: But then there's the reverse. When they want to tighten, they can either sell the bonds or just let them roll off as they mature. That's quantitative tightening — QT. And that shrinks the balance sheet. Lucas: Right. And here's a really specific example that shows how deliberate this is. In 2022, the Fed announced it would start shrinking its balance sheet by up to ninety-five billion dollars a month — sixty billion in Treasuries, thirty-five billion in mortgage-backed securities. That's a huge amount of liquidity being drained from the system every month. Luna: And they did it on autopilot, almost. They set a cap and let the bonds mature without reinvesting the proceeds. Lucas: Exactly. And the reason they were so explicit about the pace was to avoid surprising markets. They wanted to signal that this wasn't a panic move; it was a gradual normalization. But even with that communication, we saw ripple effects in financial conditions. Luna: So how does the balance sheet actually connect to what we pay in mortgages or what companies pay to borrow? I mean, I know yields go up, but what's the mechanism? Lucas: Good question. When the Fed buys long-term Treasuries, it directly reduces the supply available to investors. That pushes prices up and yields down. That anchors the whole yield curve lower, so mortgage rates and corporate bond spreads follow. Conversely, when the Fed is shrinking the balance sheet, it's essentially increasing the supply of bonds that the market has to absorb. That puts upward pressure on yields. Luna: So it's a supply and demand story for government bonds, which then transmits to the rest of the economy. Lucas: Exactly. And there's a term for the extra yield investors demand for holding longer-term bonds because of that supply: the term premium. We actually did an episode on that a while back. But the balance sheet is one of the main tools that influences it. Luna: And it's not just the Fed. The ECB and the Bank of Japan have used similar playbooks. In fact, Japan has been doing QE for so long that their balance sheet is now bigger than their GDP. Lucas: That's a striking stat. The Bank of Japan holds enormous amounts of government bonds, and they've also bought ETFs. That's a whole different level of intervention. But it shows how balance sheet policy can become a structural feature, not just a crisis tool. Luna: So is the balance sheet always in play, or is it just for emergencies? I mean, the Fed is still shrinking its balance sheet as of 2026, even while they've been cutting rates. How does that work? Lucas: That's a really good point. In 2026, the Fed has been in a cutting cycle, but they're also still shrinking the balance sheet, just at a slower pace. That's a subtle but important distinction. They're using the two tools in opposite directions — lower rates to ease, but QT to tighten. It's a way to fine-tune the economy. Luna: So they can have one tool pushing and another pulling. That must make communication tricky. Lucas: It absolutely does. And it's something that markets watch really closely. Because the balance sheet isn't just about the size — it's also about the composition. If the Fed is holding mortgage-backed securities, that keeps mortgage rates lower than they'd otherwise be. When they let those roll off, mortgage rates feel it directly. Luna: And the housing market feels that. We've seen that in the data over the past year or two, where mortgage rates stayed elevated even as the Fed cut rates, partly because of the ongoing QT. Lucas: That's a great connection. And it shows why you can't just look at the federal funds rate in isolation. You have to look at the whole balance sheet picture. There's a phrase we use in economics: the policy stance is a combination of the interest rate and the balance sheet. They work together. Luna: So when people talk about the Fed being 'tight' or 'loose,' it's not just about rates, it's about the whole balance sheet operation. Lucas: Right. And sometimes that gets lost in the headlines. But the balance sheet has been a critical tool in every major crisis since 2008. And it's also become a normal part of the toolkit, even in calm times. Luna: Before we go deeper, Lucas — and this is something I think a lot of our listeners feel — we've been putting out these episodes for years now, and the reason we can keep doing it without ads is because of a small group of listeners who chip in monthly. Lucas: That's a good point. We don't have big sponsorship deals or anything like that. It's literally funded by listeners who support us on buy me a coffee dot com slash fexingo. And that's what lets us keep making these deep dives. Luna: Yeah, it's a way to keep this ad-free and independent. If that's something you're into, you know where to find it. But back to the balance sheet. Lucas: So let's talk about the mechanics of how the balance sheet is actually managed day to day. The Fed doesn't just wake up and decide to buy a billion dollars of bonds. They have a whole operational framework. They use open market operations, and they set the interest rate on reserves, which is a key tool for keeping the fed funds rate in its target range. Luna: Right, the interest on reserves — that's the rate the Fed pays banks on the reserves they hold at the Fed. That helps anchor the bottom of the rate corridor. Lucas: Exactly. And that's another way the balance sheet interacts with rates. When banks have lots of reserves, the Fed can control rates by paying interest on them. So the size of the balance sheet directly affects how the Fed implements its rate decisions. Luna: So it's all interconnected. The balance sheet isn't just a standalone thing; it affects the plumbing of the whole financial system. Lucas: Exactly. And that's why central banks are so careful about communicating their balance sheet plans. They don't want to surprise anyone. They release projections, they have press conferences, they publish minutes. All of that is to manage expectations. Luna: And expectations matter because the balance sheet works partly through confidence. If markets think the Fed is going to keep buying bonds, that's already priced in. Lucas: Right. And that's where the 'stealth' aspect comes in. Sometimes the balance sheet does the work without a headline rate cut. For example, after the 2008 crisis, the Fed kept rates near zero, but it was the QE that really provided the extra stimulus. And in 2020, they did emergency QE again, buying Treasuries and mortgage-backed securities at a massive pace to stabilize markets. Luna: And we're still living with some of that balance sheet expansion today. Even after years of QT, the Fed's balance sheet is still well above pre-pandemic levels. Lucas: That's true. As of mid-2026, the Fed's balance sheet is still around seven trillion dollars, down from the nine trillion peak, but still much higher than the four trillion before the pandemic. So they've made progress, but it's a slow process. Luna: And that slow process is deliberate. They don't want to drain too much liquidity too fast, which could cause market stress like we saw in 2019 when they had to intervene in the repo market. Lucas: Oh, that's a great example. In September 2019, the Fed's balance sheet had been shrinking, and suddenly there was a shortage of reserves in the repo market. Overnight rates spiked, and the Fed had to step in and add reserves again. It was a reminder that balance sheet policy has to be managed carefully. You can't just shrink it indefinitely without breaking something. Luna: So it's not just about the direction, but the pace and the composition. And that's why central banks are so data-dependent on this too. Lucas: Exactly. And looking ahead, the big question is: will the Fed ever get back to a pre-crisis balance sheet size? Or is the new normal a permanently larger footprint? Most economists think it's the latter. The system runs on reserves, and the Fed needs to hold enough to maintain control over rates. Luna: So the balance sheet is here to stay as a policy tool. It's not just a crisis measure anymore. Lucas: Right. And I think that's the takeaway from today's episode. When you read about the Fed or any central bank, don't just look at the interest rate decision. Look at what they're doing with their balance sheet. That's where a lot of the real policy action is.