Federal Reserve economists warn that central banks face an "impossible trilemma" of balancing the size of their balance sheets, intervention, and interest rate stability.

According to economists at the Federal Reserve, the Federal Reserve must now face the question of what level its balance sheet should be maintained at after halting the reduction of its $6.5 trillion asset portfolio. Researchers Boole Duugen-Bond and R. Jay Cain wrote in a paper published on Wednesday that determining the optimal size of the Federal Reserve's balance sheet involves a trade-off between smaller scale, low interest rate volatility, and limited market intervention. The researchers wrote, "The Federal Reserve faces an 'impossible triangle' of its balance sheet because they can only achieve two out of these three goals at a time. The potential tension between these goals stems from the financial sector's demand for reserves and the frequency of sudden changes in liquidity supply and demand." In December of last year, as signs of banks' reserves becoming increasingly strained became apparent, short-term money market pressures intensified to $12.6 trillion, prompting the Federal Reserve to end its over three-year balance sheet reduction. Against the backdrop of the 2008 global financial crisis and the COVID-19 pandemic, driven by a series of large-scale asset purchase programs, the Federal Reserve's balance sheet expanded from just $800 billion nearly 20 years ago to a peak of up to $8.9 trillion in June 2022. There seems to be a divergence among central bank officials on how low bank reserves should be reduced in order to return the balance sheet to pre-crisis levels. Federal Reserve Vice Chair Michele Bowman has advocated for the Federal Reserve to seek the smallest possible balance sheet size. In 2019, the Federal Reserve decided to switch from holding large amounts of Treasury securities to a so-called "ample reserves" regime. As part of the current operating system, the Federal Reserve pays interest on reserves held by banks and on money market funds temporarily held at the Federal Reserve. Last month, due to money market interest rates remaining elevated before year-end pressures, the Federal Reserve announced that it would begin "reserve management purchases" to keep its reserve levels at an ample supply. Federal Reserve economists wrote, "This 'impossible triangle' underscores that central banks must decide to what extent they absorb liquidity changes through the balance sheet size, through frequent market interventions, or allow them to lead to interest rate volatility." They stated that regardless of the choice made, "central banks almost always leave a mark," whether that mark is through the assets they hold or through market operations. The massive balance sheet increases the central bank's structural impact in financial markets, creating a safe and highly liquid asset buffer that prevents short-term interest rate volatility without the need for regular Federal Reserve interventions. The authors wrote that operating with fewer reserves would increase volatility in the money market, forcing market participants to adapt to liquidity pressures. However, this could also weaken the Federal Reserve's control over interest rates, making monetary policy transmission complex, especially in the event of unforeseen shocks. Policymakers may choose to tolerate some level of interest rate volatility at certain times (such as quarter-end reporting dates) and respond with additional market operations and slightly larger balance sheet sizes. However, the authors pointed out that frequent use of Federal Reserve tools could distort market signals, similar to concerns raised by the large balance sheet. The authors wrote that the appropriate steady-state size of the balance sheet "remains an open issue, as economists or policymakers have not yet reached a consensus on this issue."