In March, the Federal Reserve should conclude the expansion of its US$ 8.8 trillion balance sheet and then begin to implement what will likely be several interest rates hikes this year. Still, like many other central banks that engaged in large-scale asset purchases (LSAPs), the balance sheet remains outsized. Globally, central bank balance sheets have ballooned to roughly US$36 trillion. Enlarging central bank balance sheets, while important for deploying maximum monetary policy accommodation, are simultaneously creating financial stability risks.

These risks are plentiful. Prolonged maintenance of a large balance sheet exposes the central bank to financial market developments that might reduce the values of assets on the balance sheet while leaving the liabilities. For instance, the Fed’s large exposure to US Treasury assets leaves it vulnerable to potential sovereign debt downgrades associated with debates about raising the government’s debt ceiling. Additionally, LSAPs could potentially crowd out some investors from sovereign debt markets who are unable to or would prefer not to invest in riskier assets. LSAPs can also potentially generate inflation and depreciation of the local currency. Finally, outsized balance sheets can also cause credibility risks if investors do not believe that they can be paired down successfully.

For more information about financial stability risks see StraightTalk® A Deep Dive on Risks to the Outlook. For more about Fed policy and risks see Executive's Guide to Fed Policy and Associated Risks: Part 2.