The Federal Reserve Confronts a 'Trilemma' Over Future Balance Sheet Size

The Federal Reserve is once again confronting a familiar but unresolved question: how large should its balance sheet ultimately be now that it has paused efforts to shrink its roughly $6.5 trillion portfolio. According to economists at the central bank, there is no easy answer and meaningful trade-offs are unavoidable.

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In a research paper released Wednesday, Fed economists Burcu Duygan-Bump and R. Jay Kahn outlined what they describe as a “balance sheet trilemma.” Their analysis argues that central banks can realistically achieve only two out of three desired objectives at any given time: maintaining a smaller balance sheet, minimizing interest-rate volatility, and limiting intervention in financial markets.

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“The tension arises from the financial system’s demand for reserves and the frequency of sudden shifts in liquidity supply and demand,” the authors wrote. In short, the structure of modern financial markets makes it difficult for central banks to keep their footprint small while also ensuring smooth market functioning without frequent intervention.

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The debate has taken on new urgency after the Fed ended its balance-sheet runoff in December, concluding a more than three-year effort to reduce asset holdings. That decision came after stress began to surface in the $12.6 trillion short-term funding markets, signaling that bank reserves were no longer as plentiful as policymakers had assumed.

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The scale of the Fed’s balance sheet reflects the extraordinary measures taken over the past two decades. At its peak in June 2022, total assets reached nearly $8.9 trillion, up dramatically from about $800 billion in the early 2000s. That expansion was driven by multiple rounds of asset purchases following the 2008 global financial crisis and later during the Covid-19 pandemic, when the central bank stepped in to stabilize markets and support the economy.

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While the Fed has since attempted to unwind those holdings, officials remain divided over how far that process should go. Some policymakers, including Vice Chair for Supervision Michelle Bowman, have argued that the Fed should aim for the smallest balance sheet possible, consistent with effective monetary policy implementation.

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Others point to lessons learned during previous episodes of market stress. In 2019, for example, disruptions in the overnight funding markets prompted the Fed to shift toward what it calls an “ample reserves” framework.

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Under this system, the central bank holds a sizable portfolio of Treasury securities and pays interest on reserves that banks keep on deposit, as well as on cash temporarily placed at the Fed by money market funds.

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That framework remains in place today. Last month, the Fed announced it would begin reserve management purchases to ensure reserves remain ample, particularly as money market rates stayed elevated ahead of year-end funding pressures. The move underscored the central bank’s desire to avoid a repeat of liquidity shortages that could destabilize short-term markets.

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According to the authors, the balance sheet trilemma forces policymakers to choose how liquidity fluctuations are absorbed. They can allow the size of the balance sheet to adjust, intervene frequently in markets to smooth conditions, or tolerate greater interest-rate volatility. But they cannot fully avoid trade-offs.

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“No matter the approach,” the economists noted, “the central bank will almost always have a footprint,” either through the assets it holds or the operations it conducts to manage liquidity.

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Maintaining a larger balance sheet offers clear advantages. It creates a buffer of safe, liquid assets that can dampen short-term rate swings without requiring constant Fed intervention. This structure can help stabilize funding markets and support more predictable monetary policy transmission.

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On the other hand, operating with leaner reserves would likely result in greater volatility in money markets, forcing participants to respond more actively to shifts in liquidity. While that approach could reduce the Fed’s presence in markets, it may also weaken its control over short-term interest rates, particularly during unexpected shocks or periods of stress.

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The authors also outlined a middle-ground option. Policymakers could tolerate occasional spikes in rate volatility such as around quarter-end reporting dates and respond with targeted market operations when needed.

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That approach would allow for a somewhat smaller balance sheet but would still require frequent use of policy tools. Over time, however, repeated interventions could distort market pricing, raising concerns similar to those associated with a permanently large balance sheet.

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Ultimately, the researchers concluded that there is no agreed-upon answer. The ideal long-term size of the Fed’s balance sheet remains unsettled, with economists and policymakers divided on how best to balance efficiency, stability, and market discipline.

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For investors, the discussion highlights an important reality: even as inflation, growth, and interest rates dominate headlines, the structure of the Fed’s balance sheet continues to play a critical role in shaping liquidity conditions and market behavior. How the central bank resolves this trilemma will influence everything from short-term funding rates to the frequency of policy interventions and remains one of the most consequential unanswered questions in modern monetary policy.

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