Monetary Policy with a Large Balance Sheet: Lessons from the Financial History of the United States

Abstract

This paper examines how monetary policy implementation with a large balance sheet relies upon interest on excess reserves. The paper then examines the Federal Reserve System balance sheet from its inception in 1914 until the end of 2015. Noting periods when it either increased rapidly or was large relative to activity measures, we focus on the onset of the U.S. participation in World War One (WWI), the Great Depression, and the World War Two (WWII) experience. The rapid reduction in the Fed balance sheet following WWI was associated with a sharp real contraction, whereas the more gradual decline that followed WWII was associated with better real outcomes. The current Federal Reserve balance sheet will likely contract by between $1 trillion to $1.75 trillion to “normalize,” and can contract gradually by allowing securities to mature without reinvestment. The large balance sheet might compromise policymaking if it persists indefinitely. Effective monetary policy could be threatened if, through a misunderstanding, interest on excess reserves was made unavailable. In a scenario analysis, the paper shows how Federal Reserve interest rate control would be compromised and force a sharp contraction of Federal Reserve credit, a speed more rapid than the unfavorable WWI credit contraction.