As Kevin Warsh launches a review of the Federal Reserve’s balance sheet, the central bank faces a pivotal question about how it will implement monetary policy in the years ahead. Warsh announced at his press conference last week that he is establishing task forces to examine several issues related to monetary policy. One of these task forces will focus on the costs and risks associated with the size and composition of the Fed’s balance sheet. In the past, Warsh has argued that the balance sheet is too large and has urged the Fed to move over time to a smaller, simpler structure. However, there are benefits as well as costs to the Fed’s current balance sheet, and the task force should consider both when developing its recommendations.

What The Fed’s Balance Sheet Actually Includes

The main assets of the Fed are its securities holdings — generally government securities such as Treasury securities and agency mortgage-backed securities. In times of stress, it also makes loans to banks and others, but in normal times those are very small. The Fed’s largest liabilities are currency, the reserve balances of banks at the Fed, and the Treasury’s deposits at the Fed.

Banks hold reserves because they need them to make payments for themselves and for their customers. Similarly, the Treasury holds money in its account at the Fed because the Fed serves as the bank for the Treasury. Currently, Fed assets total about $6.7 trillion,........

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