Other than the qualitative guidance I mentioned earlier, and an expectation that the level of reserve balances will be appreciably below that seen in recent years but larger than before the financial crisis, the FOMC has not specified how large the balance sheet should be.8 My colleague Lorie Logan spoke recently on the many technical drivers of this level, which include the mode of policy implementation that the FOMC chooses in the longer run, possible increases in recent years in the financial system’s demand for reserves and Federal Reserve reverse repo liabilities owing to new financial regulations and other factors, and the long-term evolution of demand for paper currency.9  Considerations in reducing the balance sheet size In theory, reducing the size of the balance sheet is quite simple. There are two ways to go about it.10 One approach is to simply let securities holdings mature. Principal matures on the Fed’s securities holdings all the time: Treasury bonds mature at specified dates, and agency MBS principal is repaid over time as home loans are paid back.11 For the past several years, the securities portfolio has been maintained at a steady level by reinvesting these principal repayments.12 This activity can be reduced or stopped. A second approach is to simply sell securities on the open market, using a similar procedure to the way the securities were purchased to begin with. Either way, the securities end up back in private hands. This is obvious in the case of sales.
The maturity composition of the Treasury portfolio, not shown in the figure, would be different from what it was before the financial crisis. On the liability side, at normalization, non-reserve liabilities in the median scenario would be considerably larger than they were pre-crisis. Some of the growth in the reverse repo programs we have observed since the crisis might be a second-round effect stemming from the growth in reserves, and therefore some decline in this category is possible as the overall balance sheet size declines. However, my overall read is that much of the increased demand for non-reserve liabilities, particularly currency in circulation, is likely to be persistent past normalization, and indeed demand for reserves is also likely to be higher.7 But what is the longer-run appropriate size for the balance sheet?