The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy

A consequence of the unconventional policies adopted by the Federal Reserve during the financial crisis and subsequent recession is that its balance sheet is about five times larger than prior to the crisis. A return to the pre-crisis operating regime of adjusting bank reserves to achieve a fed funds rate target would likely require a dramatic reduction in the current balance sheet. Some suggest that the Fed replace the funds rate target with the interest rate it pays on reserves (IOR) as the instrument of policy. This regime would untether the balance sheet from the conduct of monetary policy, eliminating the necessity of shrinking the current balance sheet and freeing the Fed to use the balance sheet for other purposes. I focus on the ramifications of a balance sheet unconstrained by monetary policy. My concerns stem, in part, from the nature of our institutions and the incentives of political actors and policy-makers that must operate within these institutions. A large balance sheet untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed's balance sheet to conduct off-budget fiscal policy and credit allocation. Such actions would undermine independence and further politicize the Federal Reserve.