Sometimes the Federal Reserve will buy fixed income products (like Treasuries and Mortgage Backed Securities) from commercial banks. This is a mechanism that the Federal Reserve uses to conduct quantitative easing. In the attached graph, the blue line represents the total amount of assets (fixed income assets purchased during QE) held by the Federal Reserve. In the midst of the Great Financial Crisis and the COVID pandemic, the assets held by the Fed increased dramatically. These assets are balanced with a liability, that being bank reserves. So essentially, in periods of acute economic stress, the Federal Reserve has purchased assets from commercial banks and in doing so created bank reserves out of thin air.

Inflation (shown in the green line on the chart did not break 3% in the years following 2008, and the economy operated with close to 2% inflation (which is the Federal Reserve’s target for inflation) for the decade between the GFC and COVID.

The dramatic QE the Fed conducted in the early months of COVID took some time to percolate throughout the economy, but by March 2021 inflation was at 2.8 percent and by March 2022 it had gotten to 7.4 percent. The Fed would begin to shrink their balance sheet in April 2022 and by November 2024 they had gotten the balance sheet back to 7 trillion dollars, about where it stood after their early COVID actions. Inflation had fallen back to 3.1 percent and further progress back to 2 percent seemed like a reasonable near-term goal. Inflation would briefly dip below 3 percent in the first half of 2025 before moving back to 3.6 percent by the end of the year. The concerning thing is inflation has lurched back to 4.4 percent and the balance sheet has begun to grow once again.

The persistent inflationary pressures have undoubtedly left American consumers disappointed in the economy. A consequence of inflation is that it causes interest rates to increase. The 10-year Treasury yield (the orange line on the graph) represents the cost of borrowing money. In the post GFC environment, the 10-year yield hung around in the 1.5 to 3 percent range. The early months of COVID, and the Federal Reserve’s aggressive buying of Treasuries, led the 10-year note’s yield getting below 1 percent. In the years following, the yield has approached, but not crossed 5 percent. It now seemingly trades between 4 and 5 percent. The recent spike in global crude oil prices has resulted in the yield sitting closer to 4.25 percent.

The growth of the Fed’s balance sheet since COVID seems to have been too much for the economy to comfortably digest, leading to persistent inflation. As a new Fed Chair, Kevin Warsh, looks to further shape American monetary policy, properly managing the institution’s balance sheet will likely be a critical and challenging feat.