The Fed's balance sheet, part 1: What is it - and why should we care?

Every year, hundreds of billions of dollars in new money are created from nothing by the Federal Reserve System and pumped into our economy. And since March of 2020, the Fed has created trillions of dollars’ worth of this new money. This money isn’t coming from taxes, and it doesn’t even necessarily increase the national debt--it’s simply keyed into existence by computers. This is a normal and vital function in our economy, as it is in every other major economy in the world. The entities that do it are called central banks, and the Fed is our central bank. 

That the Fed and other central banks (like the Bank of England or the Bank of Japan) create money out of thin air--trillions of dollars worth, no less--comes as a surprise to many. We have been taught the faulty analogy of our government’s budget being like a household budget, and what household gets to just create new money when it wants?  But as America’s central bank, managing the money supply, which includes issuing new money, is quite literally the Fed’s job. The Fed is tasked with making sure that our economy doesn’t have too much or too little money in circulation. If there’s too much money and not enough production of goods and services--in other words, not enough stuff for money to buy--that can lead to inflation. But if there’s too little money, the economy gets jammed up like an engine low on oil as we run short of money to pay people to produce or buy goods and services.

So where, exactly, is all this money the Fed creates going? To find out, we have to look at the Fed’s balance sheet.

Most banks in America have  deposit accounts with the Fed--just like you have a checking account with your bank. We call these Reserve Accounts. While the Fed does actually create some physical currency that it puts into circulation (which is part of why your dollar bills say ‘Federal Reserve Note’ across the top), in the vast majority of cases, the Fed creates new money by simply crediting banks’ Reserve Accounts using computer keystrokes. They simply increase the amount of money in banks’ Fed deposit accounts by changing numbers in digital ledgers, not by moving money from other accounts. The Fed typically puts money in another bank’s account in exchange for either financial securities (like Fannie Mae bonds or Treasury bills) or by directly lending  to a bank. When the Fed creates money and exchanges it like this for an asset, it is referred to as the Fed ‘monetizing’ that asset. 

Here’s an example to help visualize what’s going on: imagine that you start up a new bank and take $100 in deposits and loan $10 of that to a business. Now your bank has $90 in deposits and a loan worth $10--which, like the remaining $90, is an asset for your bank. Now if your bank sells that loan to the Fed for $10, the Fed will create $10 of new money to pay your bank for the loan. And corresponding to this new asset the Fed acquires, the Fed will have a new $10 liability in the form of $10 added to the deposit account of your bank. And voila--new money enters the economy! 

The above example illustrates how the Fed creates money to buy an asset, but in reality the Fed doesn’t just go around buying any assets from, and giving loans to, any bank that wants it. The Fed has a host of ‘Policy Tools’ that include operating rules on what the Fed will buy, and who it will buy from or lend to. But no matter how the Fed purchases these assets, the resulting transaction ends up on the Fed’s balance sheet--with the asset it purchased or the loan it made in the ‘assets’ column, and with the corresponding money it created to make that purchase in the ‘liabilities’ column. So looking at the assets on the Fed’s balance sheet allows us to see what parts of our economy the Fed is financing or, in difficult times, propping up, and thus who it is directing all this new money to.

The trillions of dollars the Fed creates carry tremendous power — the power to build new industries, create millions of jobs, and upgrade the American economy, or the power to simply inflate asset prices and help gamblers make more money speculating on stocks. To start to understand how that power is used today, we have to look at what’s on the Fed’s balance sheet, and who the Fed is giving money to through loans and asset purchases. The next post will dive into exactly that.