August 03, 2020

Economics Group

Special Commentary Jay H. Bryson, Chief Economist

jay.bryson@wellsfargo.com ● (704) 410-3274
Michael Pugliese, Economist
michael.d.pugliese@wellsfargo.com ● (212) 214-5058
Hop Mathews, Economic Analyst
hop.mathews@wellsfargo.com ● (704) 383-5312

Implications of Fed Balance Sheet Growth

Executive Summary
As a follow-up to a recently published report, we explore the implications of the phenomenal
increase in the Fed’s balance sheet so far this year. In our view, the expansion of the Fed’s balance
sheet is largely benign from an economic and financial standpoint, at least in the foreseeable future.
Higher money supply growth likely will not lead to a spike in inflation anytime soon, and the Fed’s
purchases of high quality assets, such as U.S. Treasury securities, likely will keep bond yields low
and liquidity ample in short-term funding markets. However, the Federal Reserve could become
technically insolvent if it were to experience significant credit losses on some of the higher risk
assets it is currently purchasing. In that event, the Fed could face a political backlash that could
have potential implications for its ability to respond to future crises.
Could Balance Sheet Expansion Lead to Higher Inflation?
We estimated in a report that we published on July 14 that the size of the Fed’s balance sheet, which
currently stands at nearly $7.0 trillion, would grow to roughly $7.6 trillion by the end of 2020,
under our base-case scenario. But in a “worst-case” scenario, in which the economy rolls over again
and tensions in financial markets spike anew, the balance sheet could easily explode to $11 trillion
by the end of the year. What are the implications of this significant growth in the size of the Fed’s
balance sheet?
As we discussed in our previous report, the current policy instruments of the Federal Reserve
operate largely through the asset side of its balance sheet. That is, the Fed has been actively
purchasing assets to reduce tensions in financial markets and to support the credit-creation process
in the U.S. economy. The liability side of the balance sheet is essentially moving in a mechanical
fashion with the asset side. In that regard, the reserves that commercial banks hold at the Fed have
shot up to roughly $2.7 trillion from $1.7 trillion in early March (Figure 1).
Along with vault cash, banking system reserves constitute the monetary base, which is also known
as “high-powered money.” Because commercial banks need to hold only a fraction of their deposits
(liabilities of a commercial bank) in the form of vault cash and reserves at the Fed (assets of a
commercial bank), banks can create a multiple of loans and deposits when reserves increase. In
short, rapid reserve expansion could potentially lead to a significant rise in the money supply, which
could prove to be inflationary.
On a year-ago basis, the monetary base in July was up about 45% (Figure 2). But this marked
On a year-ago
acceleration in the monetary base since March pales in comparison to the experience of the
basis, the
financial crisis of a decade ago when “high-powered money” was surging in excess of 100%. Growth
monetary base
in the M2 money supply edged higher in late-2008/early-2009, but clearly not to the same extent
in July was up
as the “high-powered” money supply.1 As we will discuss subsequently, the so-called “velocity” of
about 45%.
money fell sharply during the financial crisis, which kept a lid on growth in the M2 money supply.

1The M2 money supply includes currency in circulation, demand deposits, savings and time deposits, and
balances in retail money market mutual funds. The M2 money supply stood at $8.4 trillion in mid-2009. It
totals more than $18 trillion today.

This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

 Implications of Fed Balance Sheet Growth WELLS FARGO SECURITIES
August 03, 2020 ECONOMICS GROUP

Furthermore, headline and core consumer price inflation both fell in the immediate aftermath of
the financial crisis.
Figure 1 Figure 2
Commercial Bank Reserves Money Supply Growth
Trillions of Dollars Year-over-Year Percent Change
$3.5 $3.5 120% 120%
Millions

Millions
Bank Reserves: Jul-29 @ $2.6T Monetary Base: Jul @ 45.9%
$3.0 $3.0 M2: Jun @ 22.9%
100% 100%

$2.5 $2.5 80% 80%

$2.0 $2.0 60% 60%

$1.5 $1.5 40% 40%

$1.0 $1.0 20% 20%

$0.5 $0.5 0% 0%

$0.0 $0.0 -20% -20%

03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 00 02 04 06 08 10 12 14 16 18 20

Source: Federal Reserve Board and Wells Fargo Securities

But could this time be different? The M2 money supply in June was up nearly 23% on a year ago
basis. Not only is currency in circulation 13% higher than it was last year at this time, but deposits
at the nation’s commercial banks are up more than 20% on a year-ago basis. Could this acceleration
in the M2 money supply lead to higher inflation?
If financial
crisis is any In the near term, the answer appears to be “no.” Both overall and core CPI inflation have receded
guide, inflation notably since the pandemic struck earlier this year (Figure 3). And if the experience of the financial
likely won’t crisis is any guide, inflation likely won’t shoot higher as long as the economy remains depressed.
shoot higher as But could inflation rise significantly in the years ahead? For that to happen, the velocity of money
long as the would need to reverse the downward trend that it has followed for the past few decades (Figure 4).
economy Figure 3 Figure 4
remains
depressed. U.S Headline CPI vs. Core CPI Velocity of M2 Money Stock
Year-over-Year Percent Change Ratio of Nominal GDP to M2
6% 6% 2.4 2.4
Velocity of M2: Q2 @ 1.1
5% 5%
2.2 2.2

4% 4%
2.0 2.0
3% 3%

2% 2% 1.8 1.8

1% 1% 1.6 1.6

0% 0%
1.4 1.4
-1% -1%

1.2 1.2
-2% -2%
CPI: Jun @ 0.6%
Core CPI: Jun @ 1.2%
-3% -3% 1.0 1.0
92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 59 63 67 71 75 79 83 87 91 95 99 03 07 11 15 19

Source: U.S. Department of Labor, Federal Reserve Bank of St. Louis and Wells Fargo Securities

The velocity of money is the number of times that a unit of money (currency in circulation and bank
deposits) is used to buy goods and services during a period of time. An increase in the velocity of
money would support higher spending on goods and services, everything else equal, which could
lead to higher inflation if resource constraints inhibit businesses from ramping up output quickly
Although it is not entirely clear why money velocity has declined over the past two decades, the low
interest rate environment over that period has likely played a role. That is, individuals are willing
to hold excess cash balances if other assets are earning low rates of return. In addition, low

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Implications of Fed Balance Sheet Growth WELLS FARGO SECURITIES
August 03, 2020 ECONOMICS GROUP

inflationary expectations probably have contributed to the decline in the velocity of money as well. The recent
If individuals do not expect inflation to increase significantly, then they do not feel necessarily increase in the
compelled to spend their cash balances before higher inflation erodes their purchasing power. As size of the Fed’s
long as interest rates remain low and inflationary expectations remain depressed, a marked balance sheet
increase in the velocity of money does not seem likely. In other words, the recent increase in the probably will
size of the Fed’s balance sheet probably will not lead to significantly higher inflation anytime soon. not lead to
As a point of reference, note that the balance sheet of the Bank of Japan (BoJ) has ballooned to significantly
nearly 120% today from 30% of Japanese GDP at the beginning of 2012. Over that period, the higher inflation
consumer price index in Japan has risen less than 6%, which is an annual average rate of only 0.7%. anytime soon.
Clearly, balance sheet expansion by the BoJ has not led to a significant bout of inflation in Japan.2
This is not to say an exploding monetary base cannot lead to higher inflation, but rather that it does
not necessarily need to lead to higher inflation.
Bond Yields: An Unstoppable Force Meets an Immovable Object
The Fed’s robust purchases of Treasury securities have helped keep a lid on yields despite the surge
in federal debt issuance. The federal budget deficit has ballooned since the onset of COVID-19, and
with it has come an explosion of debt issuance by the federal government that has already surpassed
the peaks seen during the Great Recession (Figure 5). This has led some financial market
participants to speculate that a jump in bond yields is in the offing.
Figure 5 Figure 6
Net Treasury Issuance Composition Net Treasury Issuance Composition
Billions of Dollars, Change in Marketable Treasuries Outstanding Billions of Dollars, Net of Fed Purchases/Redemptions
$5,000 $5,000 $3,000 $3,000
Net Coupon Issuance: 2020 @ $1,637.0B Privately-Held Net Coupon Issuance: 2020 @ -$548B
$4,500 Net T-Bill Issuance: 2020 @ $2,087.0B WFS $4,500 Privately-Held Net Bill Issuance: 2020 @ $1,930B
Fcst $2,500 $2,500
$4,000 $4,000 WFS
Fcst
$2,000 $2,000
$3,500 $3,500

$3,000 $3,000 $1,500 $1,500

$2,500 $2,500
$1,000 $1,000
$2,000 $2,000

$1,500 $1,500 $500 $500

$1,000 $1,000
$0 $0
$500 $500
-$500 -$500
$0 $0

-$500 -$500 -$1,000 -$1,000

00 02 04 06 08 10 12 14 16 18 20 00 02 04 06 08 10 12 14 16 18 20

Source: U.S. Department of the Treasury and Wells Fargo Securities

But, just looking at the change in public debt outstanding ignores the role the Federal Reserve plays
in the Treasury market. After accounting for the Fed’s Treasury security purchases/redemptions,
total net Treasury issuance this year will only be moderately higher than it was during the Great
Recession. And for net issuance of securities with maturities of two years or longer, our forecast is
for supply to be outright negative by more than $500 billion, after accounting for Fed purchases
(Figure 6). This illustrates just how aggressive the Federal Reserve has been in the Treasury market
since mid-March. At the peak, the Fed was buying $75 billion per day of Treasury securities, none
We forecast that
of which were short-dated Treasury bills. This explosion in Treasury holdings by the central bank
the yield on the
easily exceeds what was done by the Federal Reserve during and after the Great Recession
10 year
(Figure 7).
Treasury
This is not to say that debt issuance will have no impact on markets going forward. The Fed has security will
subsequently dialed back its purchases to $80 billion per month, and the U.S. Treasury Department stand at roughly
likely will continue to ramp up issuance of intermediate and longer-dated Treasury securities in the 1.5% at the end
quarters ahead. But it is our expectation that increased debt issuance will push up longer-dated of 2021.
yields only at the margin over the next 12-18 months. Specifically, we forecast that the yield on the

2 At present, the Fed’s balance sheet is equivalent to roughly 30% of nominal GDP in the United States.

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 Implications of Fed Balance Sheet Growth WELLS FARGO SECURITIES
August 03, 2020 ECONOMICS GROUP

10-year Treasury security will stand at roughly 1.5% at the end of 2021, which would still be about
50 bps below where it was at the end of 2019. For a more material breakout in Treasury yields, the
economy would need to strengthen enough such that financial markets begin to price in at least
some Fed rate hikes in the 2020s (Figure 8).
Figure 7 Figure 8
Change in Federal Reserve Treasury Holdings USD OIS Curve
4-Quarter Rolling Sum, Billions of USD Overnight Index Swap Rates
$3,000 $3,000 0.15% 0.15%
Fed Purchases (+)/Redemptions (-): Q2 @ $1,773.2B July 28, 2020

$2,500 WFS $2,500

Fcst

$2,000 $2,000
0.10% 0.10%

$1,500 $1,500

$1,000 $1,000

0.05% 0.05%
$500 $500

$0 $0

0.00% 0.00%
-$500 -$500
07 08 09 10 11 12 13 14 15 16 17 18 19 20

Source: Federal Reserve Board, Bloomberg LP and Wells Fargo Securities

Liquidity: Keeping Strains in Short-Term Funding Markets at Bay

Bank reserves Liquidity concerns have periodically arisen over the past year, from the spike in repo rates in
have risen September 2019 to the widespread financial market havoc that was induced by COVID-19 in mid-
nearly $1 trillion to late-March. Since then, however, money markets and other key segments of the financial
since early plumbing have generally operated much more smoothly, aided mightily by the expansion of the
March. Federal Reserve’s balance sheet. As discussed above, bank reserves have risen nearly $1 trillion
since early March, and we anticipate that they will increase by at least another $1 trillion by year’s
end (Figure 9). Continued Fed purchases of Treasury securities and MBS, as well as an eventual
decline in the Treasury’s cash balance (Figure 10), should keep new cash flowing into the financial
system for the foreseeable future.3
Figure 9 Figure 10
Total Bank Reserves Projection U.S. Treasury Cash Balance
Trillions of Dollars Billions of Dollars
$4.5T $4.5T $2,100 $2,100
Thousands

Thousands

WFS Base-Case Projection Cash Balance: Jul-27 @ $1,830.5B

$4.0T $4.0T
$1,800 $1,800

$3.5T $3.5T
$1,500 $1,500
$3.0T $3.0T

$2.5T $2.5T $1,200 $1,200

$2.0T $2.0T $900 $900

$1.5T $1.5T
$600 $600
$1.0T $1.0T

$300 $300
$0.5T $0.5T

$0.0T $0.0T $0 $0
Q4-2019 Q1-2020 Q2-2020 Q3-2020 Q4-2020 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20

Source: Federal Reserve Board, Bloomberg LP and Wells Fargo Securities

The sources of this extra liquidity have not just been outright asset purchases by the Fed, but also
the slew of emergency lending programs by the central bank that were covered in Part I of this

3The Treasury Department can raise the cash balances it holds at the Fed by issuing more debt. As the
private sector buys Treasury securities, cash flows out of the banking system.

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Implications of Fed Balance Sheet Growth WELLS FARGO SECURITIES
August 03, 2020 ECONOMICS GROUP

report. On July 28, the Federal Reserve announced that it would extend through December 31
seven of its facilities that were scheduled to expire on September 30.4 In addition, the Federal Open
Market Committee FOMC) announced at it July 29 meeting that the Fed “will continue to offer
large-scale overnight and term repurchase agreement operations” and that it was extending the
swaps agreements that it has in place with other major central banks through March 2021.
Although usage of many of these programs may remain low in the months ahead, their continued
presence should help to ensure that liquidity is not a major problem. In short, the willingness of
the Federal Reserve to use its balance sheet to provide liquidity to financial institutions and foreign
central banks should keep strains in short term funding markets, such as those experienced in
March, at bay.
Could the Fed Become Insolvent?
While the Fed’s balance sheet has ballooned to roughly $7 trillion, its capital base has remained The Fed’s
constant at about $39 billion. With this leverage ratio of roughly 175-to-1 (Figure 11), it seems balance sheet is
plausible that a loss could wipe out the Fed’s relatively meager capital buffer and leave it with a largely
negative net worth. Although this is possible, things may not be as worrisome as this figure comprised of
suggests. The Fed’s balance sheet is largely comprised of assets with relatively minimal credit risk. assets with
While the Fed is adding new, riskier assets to its balance sheet through its crisis lending facilities, relatively
the Treasury has seeded these facilities with capital that can help protect the Fed from some default minimal credit
risk. Even if the Fed were to become technically insolvent, the consequences are much more likely risk.
to be political rather than economic.
Figure 11
Balance Sheet Leverage Ratio
Total Liabilities to Total Capital
200 200
Ratio: Jul-29 @ 178
180 180

160 160

140 140

120 120

100 100

80 80

60 60

40 40

20 20

0 0
03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20

Source: Federal Reserve Board, Bloomberg LP and Wells Fargo Securities

U.S. Treasury securities currently account for about $4.3 trillion of the $7.0 trillion worth of assets
that the Federal Reserve currently holds on its balance sheet. These securities essentially have no
credit risk because they are backed by the “full faith and credit” of the U.S. government. The Fed
also owns $2.0 trillion worth of mortgage-backed securities (MBS). Although these securities do
not explicitly have the “full faith and credit” of the U.S. government, the credit risk inherent in them
is probably fairly low. In the event of another housing market meltdown, the U.S. government likely
would backstop the MBS issued by Fannie Mae and Freddie Mac as it did during the financial crisis.
Together, Treasury securities and MBS make up about 90% of the assets on the balance sheet and
a similar share of the balance sheet’s growth since early March.
That said, the Fed has created a number of programs since March that could alter the composition
and credit risk of its balance sheet. For example, corporate bonds and state & municipal bonds,

4 These facilities include the Primary Dealer Credit Facility, the Money Market Mutual Fund Liquidity
Facility, the Primary Market Corporate Credit Facility, the Secondary Market Corporate Credit Facility,
the Term Asset-Backed Securities Loan Facility, the Paycheck Protection Program Liquidity Facility and
the Main Street Lending Program.

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 Implications of Fed Balance Sheet Growth WELLS FARGO SECURITIES
August 03, 2020 ECONOMICS GROUP

which the Federal Reserve is buying, have higher default risk than Treasury securities or MBS.
Furthermore, the loans that the Fed is now buying from commercial banks through its Main Street
Lending Program also have default risk. The amount of credit that the Federal Reserve has extended
to these facilities totals about $200 billion at present, but they could grow to a maximum of
$2.3 trillion, in aggregate. All of these facilities are capitalized by $215 billion from the U.S.
Treasury Department, which would have any first-loss exposure. However, this equity infusion
from the Treasury Department as well as the $39 billion worth of capital that the Fed holds could
be completely depleted if the credit losses incurred by these facilities exceed $254 billion.5
Of course the Federal Reserve is not an ordinary commercial bank. Congress could pass legislation
requiring commercial banks, which are the Fed’s primary equity contributors, to re-capitalize the
Fed, or the federal government could also stake a significant new equity stake in the central bank.
Although the technical insolvency of the nation’s central bank may not have tremendous economic
consequences, falling into a negative net worth situation could have significant political
implications for the Federal Reserve.
Thus far, many observers have lauded the Fed for the actions it has taken to stem the ongoing
economic crisis, but these actions have also taken it into uncharted territory. Suffering significant
credit losses on some these new programs could lead some in Congress to question whether the
Fed’s crisis mitigation efforts go beyond its mandate. New legislation or more stringent
congressional oversight could weigh on the Fed’s independence and its ability to respond to new
problems as they arise. The Federal Reserve may face some criticism even in the absence of any
solvency issues, as it did following the 2008 financial crisis. However, entering into technical
insolvency, should that eventuality transpire, could lead to a political backlash that could
potentially have implications for the Federal Reserve to respond to future crises.
Conclusion
The balance sheet of the Federal Reserve has expanded to nearly $7.0 trillion from about
$4.2 trillion in late February. Under our base-case scenario, we project that it will grow to roughly
$7.6 trillion by the end of the year, although we acknowledge that the balance sheet could climb
higher if the FOMC needs to provide even more monetary accommodation to the economy. In our
view, the economic and financial implications of rapid balance sheet expansion are rather benign,
at least in the foreseeable future. We think there is a low probability that increased growth in the
money supply will lead to a spike in inflation. The asset purchases that the Fed is undertaking
should keep bond yields low while also providing ample liquidity to the financial system.
There could be
That said, we believe there could be potential political implications from balance sheet expansion.
potential
The Federal Reserve is taking on credit risk through some of the facilities it has created to support
political
the credit-creation process in the U.S. economy. If credit losses were to become extreme, the
implications
Federal Reserve could become insolvent, at least in a technical sense. In that event, some members
from balance
of Congress and/or the administration could question whether the Fed went beyond its mandate
sheet expansion.
and they could take steps to reign in the Fed’s independence, which could conceivably constraint
the Fed’s ability to respond to future crises.

5American financial institutions wrote down more than $1.2 trillion worth of losses in the aftermath of
the financial crisis.

6
Wells Fargo Securities Economics Group

Jay H. Bryson, Ph.D. Chief Economist (704) 410-3274 jay.bryson@wellsfargo.com

Mark Vitner Senior Economist (704) 410-3277 mark.vitner@wellsfargo.com
Sam Bullard Senior Economist (704) 410-3280 sam.bullard@wellsfargo.com
Nick Bennenbroek International Economist (212) 214-5636 nicholas.bennenbroek@wellsfargo.com
Tim Quinlan Senior Economist (704) 410-3283 tim.quinlan@wellsfargo.com
Azhar Iqbal Econometrician (212) 214-2029 azhar.iqbal@wellsfargo.com
Sarah House Senior Economist (704) 410-3282 sarah.house@wellsfargo.com
Charlie Dougherty Economist (704) 410-6542 charles.dougherty@wellsfargo.com
Michael Pugliese Economist (212) 214-5058 michael.d.pugliese@wellsfargo.com
Brendan McKenna International Economist (212) 214-5637 brendan.mckenna@wellsfargo.com
Shannon Seery Economist (704) 410-1681 shannon.seery@wellsfargo.com
Jen Licis Economic Analyst (704) 410-1309 jennifer.licis@wellsfargo.com
Hop Mathews Economic Analyst (704) 383-5312 hop.mathews@wellsfargo.com
Coren Burton Administrative Assistant (704) 410-6010 coren.burton@wellsfargo.com

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