The Fed’s New Normal: A Jumbo-Sized Balance Sheet

There’s an old parable about a farmer who rides his horse across a narrow bridge each morning. One day, a storm knocks down half the bridge. Rather than rebuild, the farmer trains his horse to jump the gap. It works, until one day it doesn’t.

Some fear that horse is our monetary system, and the gap it keeps clearing is the Federal Reserve’s balance sheet. How long can we keep this up? Or do we already have a problem?

Many of you are Fed watchers, by nature of your jobs in finance, but the vast majority of Americans know little about the Fed, its role in the economy, or the impact of its balance sheet. Everyone in the latter group, this essay is for you.

Let’s take a look.

The Widening Gap

The Fed’s balance sheet has two sides: On the asset side are Treasury bonds and mortgage-backed securities—the financial instruments the Fed buys to inject money into the economy. On the liability side are the reserves that banks hold at the Fed, along with physical currency in circulation.

Every time the Fed expands its balance sheet, it’s effectively creating money—not by printing bills, but by crediting banks’ accounts with electronic reserves. Those reserves then support lending, asset prices, and the broader flow of credit through the economy. When the Fed shrinks its balance sheet, the opposite happens: those reserves disappear, tightening liquidity and raising borrowing costs.

These mechanics impact everything, including mortgage rates, stock valuations, housing prices, and business credit spreads.

From 1970 to 2007 the Fed’s balance sheet grew slowly alongside the economy, usually hovering around 5–6% of US GDP.

Then the 2008 financial crisis happened, and the Fed responded by doubling its balance sheet almost overnight—from $0.9 trillion to $2.2 trillion, or about 15% of GDP. By 2014, after three rounds of quantitative easing, it had swelled to $4.5 trillion, roughly 25% of GDP.

Then came COVID, and the Fed’s balance sheet shot into the stratosphere—reaching nearly $9 trillion in 2022, as you saw in the chart above. This was the equivalent of 36% of GDP—its highest share in modern history. For perspective, that’s roughly the size of the US mortgage market.

Today, even after nearly three years of quantitative tightening, the Fed still holds about $6.6 trillion in assets—roughly 22% of the US economy. That’s almost four times its historical share.

Why So High?

Before 2008, the Fed managed interest rates under a scarce reserves system. Banks held just enough reserves to meet regulations, and small changes in reserve supply could move short-term interest rates. It was delicate, efficient, and relatively simple.

After the crisis, the Fed switched to an ample reserves system. Instead of juggling daily liquidity injections, the Fed began paying interest on the trillions of dollars of reserves it created. The goal was greater stability and better operational control, but it required a permanently larger balance sheet.

Which begs the question: Is that a problem?

There are valid arguments for maintaining a large balance sheet. It stabilizes short-term interest rates. It acts as a crisis buffer, because banks know the Fed can provide immediate liquidity during times of stress. And it gives the Fed the option to inject more stimulus by expanding even further. Because once you’ve reached jumbo size, what’s a little bit more?

Of course, this stability and control come at a cost. Because nothing is free.

By acting as the ultimate liquidity provider, the Fed has become the biggest single player in the bond market. This has pushed investors into riskier assets, driven up valuations, and dampened traditional signals of financial stress.

The result is a dependency dynamic: the markets have been conditioned to expect the Fed to step in whenever volatility rises.

Traders call this the “Fed put”—the idea that falling stocks will eventually trigger Fed easing. This belief, whether correct or not, shapes market behavior in ways that make asset bubbles more likely.

There are fiscal implications too. When the Fed pays interest on trillions in reserves (currently over $3 trillion), that is real money—tens of billions in annual payments to commercial banks and money-market funds. In the years of near-zero interest rates, these payments were small, but today they’re substantial. According to data from the American Bankers Association the Fed paid banks $176 billion in interest last year.

Meanwhile, the Fed holds longer term bonds that have dropped in value as rates have risen, producing unrealized losses exceeding $1 trillion—about 24 times its stated capital.

Finally, there’s a real concern that with the Fed owning roughly one-fifth of all US Treasuries, normal price signals have been muted.

These concerns explain, at least in part, why the Fed has been gradually reducing its balance sheet since 2022—by about $95 billion per month. The slow pace is meant to avoid market shocks, but it also means balance-sheet “normalization” will take years.

And what will that new normal be?

No one really knows the true minimum reserves necessary to keep markets stable. Estimates range from $2.5 to $3 trillion, but Jerome Powell has said the Fed wants to maintain a balance sheet “somewhat above the level consistent with ample reserves.”

Meaning the Fed wants a buffer and will likely stabilize the balance sheet near $5–6 trillion, not return to pre-2008 norms.

That would put the new balance sheet floor at roughly 20% of GDP, or right around 2018 levels, as you can see in the chart on the right below. This would represent a permanent shift away from historical norms.

Living with the New Normal

In my conversation with Dr. Ed Yardeni earlier this week he said, the “Fed is so yesterday… everything’s been changing in the economy and the Fed’s still operating as though it’s a fairly predictable business cycle.”

He may be right, but our job is to acknowledge that we are not going to return to the simplicity of pre-2008 monetary policy. The Fed’s jumbo balance sheet is now a permanent instrument of policy, and its direction—expanding or contracting—can tells us as much about market conditions as any Fed statement.

Jacob Shapiro Returns to Global Macro Update

A warm thank you to everyone who watched my conversation with Dr. Ed earlier this week. After a long pause, my Global Macro Update interview series is back in full force, and we’re releasing our second interview of the week—this time with Jacob Shapiro, director of geopolitical research at the Bespoke Group. Watch our conversation about AI’s role in the US-China race for global hegemony by clicking here.

A transcript of our conversation is available here.

Thanks for reading and watching.

Ed D’Agostino

Partner & COO