How Much Should the Federal Reserve Shrink?

Robert Higgs, in his book “Crisis and Leviathan,” shows how the size, power, and intrusiveness of the government feed on crises. With each crisis, the government becomes bigger. After the crisis is over, it may shrink some, but it rarely goes back to its former size. The bloated balance sheet of the Federal Reserve is a perfect demonstration of this phenomenon. At the end of 2007, before the panic of 2008, the Fed produced its last historically normal annual balance sheet. It had total assets of $894 billion. It owned zero mortgage securities.During the ensuing years, the Fed vastly expanded its balance sheet to a size that was previously unimaginable. By Peak Fed in March 2022, it had total assets of $8.9 trillion, or 10 times its 2007 level. It had investments in mortgage securities of $2.7 trillion, three times its total 2007 assets.Since then, just as Mr. Higgs would predict, the Fed’s size has been reduced, but to nowhere near its previous level. As of the end of March 2026, the Fed’s total assets are still $6.7 trillion or 7.5 times their 2007 level and it still owns $2 trillion in mortgage securities, compared to the zero it should have. The Fed has stopped reducing its size — it is now $34 billion bigger than it was at the end of 2025.Whatever happened to the assurance Chairman Bernanke’s gave in 2011 to Congress that “there will be no permanent increase… in the Fed’s balance sheet”? We can consider it either a memorable broken promise or a fully flubbed forecast. The Fed has two basic parts: the mundane job of simply buying Treasury securities with the United States currency it has the monopoly on issuing; and everything else. In 2007, the mundane “Currency Fed” had $792 billion in currency outstanding, so everything else in the Fed’s balance sheet totaled only $102 billion. At Peak Fed, the “Everything Else” part of the Fed, which had come to include in effect a giant savings and loan for holding mortgage assets and an even bigger hedge fund for investing in long-term Treasury securities financed overnight, totaled $6.7 trillion. In other words, the activist, interventionist, financial risk-taking part of the Fed had increased since 2007 by 66 times. As of today, that increase is still 42 times. The financial results of the Fed’s risk taking are an aggregate operating loss of $224 billion plus a mark-to-market loss of $845 billion, or well over $1 trillion in total. These are costs not just to the Fed itself but to the Treasury and the taxpayers. In addition, the Fed’s mortgage buying spree, by driving mortgage interest rates to abnormally low levels, pushed house prices up to abnormally high levels.The “affordability crisis” in American housing thus significantly reflects the results of the Fed’s bloated balance sheet. Even though the Fed should get out of its mortgage investments, it certainly does not want to sell them now because doing so would create a more than $300 billion realized loss. On top of that, selling would drive mortgage interest rates up — a politically unacceptable result.Whether the Fed should or could shrink, and if so, how much, has become a topic of public debate. How much shrinkage would it take to get the current Fed back to the 2007 base case, appropriately adjusted?In 2007, the Fed’s assets were equal to 6.2 percent of nominal GDP and 8.3 percent of total commercial banking assets. To reach these same percentages, the Fed would have to shrink to $2 trillion in assets. This is not possible because the Fed’s assets must by definition be something greater than its currency outstanding, currently $2.4 trillion.An essential mandate of the Fed, like all central banks, is to finance the government of which it is a part. Expanding its balance sheet is a way to force the commercial banking system to lend to the government. In 2007, the Fed’s assets were 9.7 percent of the national debt. To return to this level the Fed’s assets would need to fall to about $3.8 trillion, or be reduced by $2.9 trillion. A reasonable target for the normalized size of the Fed might be a rounded to 10 percent of the national debt. The Fed’s assets would then be $3.9 trillion instead of $6.7 trillion. Since we know the Fed cannot sell its mortgage securities, however, to its allowed assets might be added its $2 trillion in mortgage securities, provided that these mortgage investments be put and kept in run-off until they reach zero again.That would suggest a current shrinkage of the Fed to $5.9 trillion, or shrinkage of $800 billion plus however much the mortgage assets run off. Of course, in the next crisis, all bets are off and the Fed’s balance sheet may bloat once more.

How Much Should the Federal Reserve Shrink?

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