# Reforming the Federal Reserve, Section 3: Restoring Sensible Asset Purchases To maintain a clear demarcation between monetary and fiscal policy, as well as minimize the Fed’s footprint on financial markets, the Fed must trade only short-term US Treasury securities and revert to its pre-2008 policy framework. June 26, 2025 • Publications By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) ![Reforming the Fed Reserve (no text)](/sites/cato.org/files/styles/aside_3x/public/2025-04/Reforming%20Fed%20Reserve_0.jpg?itok=FP84B9tQ) #### [Reforming the Federal Reserve](https://www.cato.org/reforming-federal-reserve) 9-part series - ##### [Reforming the Federal Reserve, Section 1: A Brief Look Back and the Way Forward](/publications/reforming-federal-reserve-part-1-brief-look-back-way-forward) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 2: Enforcing Rules-Based Monetary Policy](/publications/reforming-federal-reserve-part-2-enforcing-rules-based-monetary-policy) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 3: Restoring Sensible Asset Purchases](/publications/reforming-federal-reserve-part-4) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 4: Ending the Interest on Reserves Program](/publications/reforming-federal-reserve-part-5) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 5: Preventing Fiscal Dominance](/publications/reforming-federal-reserve-part-8-preventing-fiscal-dominance) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 6: Responsible Last Resort Lending](/publications/reforming-federal-reserve-part-6) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 7: A Glance at Interventions in Payment Services](/publications/reforming-federal-reserve-part-3-a-glance-at-interventions-in-payment-services) By [Nicholas Anthony](https://www.cato.org/people/nicholas-anthony) - ##### [Reforming the Federal Reserve, Section 8: Shrinking Regulatory Authority](/publications/reforming-federal-reserve-part-7) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 9: Dispelling Myths About the Fed](/publications/reforming-federal-reserve-part-9-dispelling-myths-about-fed) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) [ Return to Series Home ](https://www.cato.org/reforming-federal-reserve) [ Download PDF ](https://www.cato.org/sites/cato.org/files/2026-01/Reforming-the-Federal-Reserve.pdf) Since the 2008 financial crisis, the Federal Reserve has vastly expanded its footprint in financial markets through massive asset purchases, commonly referred to as quantitative easing (QE). What began as a temporary emergency response has morphed into a primary feature of modern central banking, resulting in the Fed’s balance sheet bloating to historic proportions—expanding from less than $1 trillion in 2007 to nearly $9 trillion at its peak in 2022, largely due to successive rounds of QE.[1](#_ednref1) These programs involved large-scale purchases of US Treasury securities and agency mortgage-backed securities (MBS) intended to lower long-term interest rates and stimulate aggregate demand. While QE was marketed as a necessary step to support economic recovery, the Fed’s foray into large-scale asset buying raises serious concerns about fiscal independence and financial stability. To maintain a clear demarcation between monetary and fiscal policy, as well as minimize its footprint on financial markets, the Fed must revert to trading only US Treasury securities and revert its asset-purchase program to its pre-2008 regime. ## Rationale Behind Quantitative Easing QE was introduced as an unconventional monetary policy tool when the federal funds rate approached its effective lower bound (i.e., the fed funds rate was effectively zero percent) and, as a result, traditional monetary policy could no longer provide additional stimulus by targeting short-term interest rates. Through QE, the Fed purchased large quantities of *longer-term* Treasury securities and agency MBS to influence broader financial conditions and support economic activity.[2](#_ednref2) The primary theoretical justification for QE lies in its ability to reduce long-term interest rates by altering the composition of assets held by the public. By absorbing large volumes of long-duration securities, the Fed aimed to compress term premiums (i.e., lower the additional compensation for holding longer-term assets versus short-term assets), thereby encouraging greater borrowing and investment.[3](#_ednref3) In addition, rising asset prices were expected to boost household wealth and stimulate consumption—a transmission channel often referred to as the wealth effect. QE was also intended to serve a signaling function. By undertaking large-scale purchases, the Fed sought to reinforce its commitment to accommodative policy for an extended period, helping anchor market expectations of low future short-term rates. Finally, during periods of financial distress, QE was thought to inject liquidity into key markets, stabilize asset prices, and restore investor confidence. There is wide debate as to whether QE worked as intended and helped the recovery from the recession.[4](#_ednref4) Regardless, QE has undoubtedly bloated the Fed’s balance sheet and led to undesired interactions with financial markets and fiscal policy beyond the Fed’s traditional role. ## Fed’s Size Disrupts Financial Markets The multiple rounds of QE following the 2008 recession and again following the COVID-19 pandemic have drastically increased the size of the Fed and fundamentally changed its relationship with the financial sector. Figure 1 shows the Fed’s asset holdings as a percentage of all the assets held by US commercial banks. Prior to the 2008 financial crisis, the Fed’s balance sheet rarely exceeded 10 percent of the commercial banking sector, with the trend exhibiting a gentle decline. After the financial crisis, however, the Fed entered a new era, with this number frequently exceeding 20 percent. The QE operations during the pandemic led to another structural jump, with the Fed reaching 40 percent of the size of all commercial banking. ![Figure 1 [web]: Federal Reserve's assets relative to entire US commercial banking sector](https://infogram-thumbs-1024.s3-eu-west-1.amazonaws.com/56f9b5e0-a398-4678-9a87-936bdef82b7a.jpg) Such a large shift in central banking has effects on the financial system. The primary effect of the Fed’s interference in asset markets is the massive reduction in reserves trading between private banks through the federal funds market. In return for the Treasurys and MBS the Fed purchased, those funds drastically increased the reserves of financial institutions, moving from a scarce-reserves regime prior to 2008 to an abundant-reserves regime. Under the new framework, banks were so flush with reserves that they no longer needed to borrow them from other banks. As a result of the policy framework switch, daily trading volume in the fed funds market fell from its pre-2008 level of $150–$175 billion to just $60–$80 billion in the mid-2010s.[5](#_ednref5) Consequently, the fed funds rate, the Fed’s key policy rate, has become much less correlated with other borrowing rates.[6](#_ednref6) This shift in framework has also had serious repercussions for financial markets.[7](#_ednref7) Before the 2008 financial crisis, increases in the Fed’s balance sheet typically led to minor *reductions* in market volatility; after the crisis, balance sheet increases are accompanied by large *increases* in market volatility. Research from the Cato Institute shows that since 2008, a 1 percent increase in assets may cause a 6 percent increase in financial market volatility.[8](#_ednref8) Market participants may now view Fed asset changes as a signal of weakening economic conditions due to the scale and frequency of QE measures. Conversely, before 2008, balance sheet expansions were less common and typically viewed as a routine adjustment or a response to relatively minor financial disruptions. ## New Types of Asset Purchases are Harmful The nature of the assets being purchased also changed post-2008, when the Fed, for the first time, expanded its asset purchases to include a large quantity of MBS. Figure 2 shows the breakdown of the securities held by the Fed. As the figure shows, until 2008, the Fed purchased Treasurys, largely of a relatively short duration.[9](#_ednref9) At their peak in 2010, MBS comprised over half the Fed’s assets. Presently, one-third of its assets are MBS, with Treasury securities comprising the remaining two-thirds. Consequently, the Fed has drastically increased its footprint by preferentially allocating credit to the housing sector and distorting it away from its market-based equilibrium.[10](#_ednref10) ![Figure 2 [web]: Percentage breakdown of Federal Reserve securities held outright by type](https://infogram-thumbs-1024.s3-eu-west-1.amazonaws.com/5ea75320-9c4d-4be3-9ce4-3d7bf596e14a.jpg) The QE program’s focus on long-term Treasury securities is also concerning because it exposes the Fed to heightened interest rate risk.[11](#_ednref11) Put differently, these long-term asset purchases mean that the Fed, to a much greater extent than in the past, now borrows short while lending long. This operation exposes the Fed to financial losses when short-term rates rise, because the Fed must pay higher rates than the rates it will receive. The Fed’s “borrowing” comes in the form of bank reserves and reverse repurchase agreements—both of which have associated interest payments and are very short-term liabilities. That is, the Fed’s profitability rests on an upward-sloping yield curve (where long-term rates are higher than short-term rates) and it faces losses if the yield curve inverts.[12](#_ednref12) The yield curve usually slopes upward, but this relationship is not guaranteed, as demonstrated by the downward-sloping yield curve experienced for much of the past few years. The Fed did not face interest rate risks of this kind, or the resulting financial losses, when it focused on short-term Treasurys in a low-rate environment. ## QE Enables Reckless Fiscal Spending The new abundant-reserves system divorces the Fed’s monetary policy stance from the size of its balance sheet by allowing it to purchase as many assets as it would like, all while paying firms to hold on to the excess cash that these purchases create. This framework can allow the Fed to be a pawn of the US Treasury for the simple reason that its asset purchases no longer directly threaten its price-stability mandate—the Fed’s operating framework is designed to pay interest on reserves for the express purpose of preventing asset purchases from funding broader money creation. Ultimately, the Fed’s current operating system increases the risk that its QE powers will be used in the funding of backdoor government spending. Federal spending is supposed to go through the congressional appropriations process, but the Fed’s new abundant-reserves regime provides a path for bypassing that process. That is, the new regime enhances the Fed’s ability to fund government programs—such as a Green New Deal, energy subsidies, or an industrial development bank—independent of the appropriations process to a much greater degree than before. Federal agencies could, for example, increase their funding by selling securities to the Fed, thus making it less likely that Congress will control government spending. Because the new regime is built upon “containing” newly created reserves, the Fed would no longer be able to stave off such backdoor funding by appealing to its congressional price-stability mandate.[13](#_ednref13) Arguably, QE could have been an effective emergency program in some circumstances. The Fed’s implementation of QE, however, has proven that such “emergency” programs are nearly impossible to contain and eliminate. Prolonged QE of this kind—it has become an all but permanent fixture at the Fed—blurs the lines between monetary and fiscal policy. Such a scenario can trigger fiscal dominance, a situation where the central bank’s ability to conduct independent monetary policy is constrained by the government’s fiscal position. The central bank is pressured, explicitly or implicitly, to help finance government debt. In such a regime, fiscal needs drive monetary policy, risking macro-instability and loss of central bank credibility—problems more typically inherent in politically unstable countries.[14](#_ednref14) ## Fixing the Balance Sheet When the QE program launched, it came with a commitment to restore asset holdings to pre-2008 levels.[15](#_ednref15) This restoration has not yet happened, nor is it likely to happen soon. At the very least, the Fed should deflate its balance sheet until it is commensurate with its size relative to the private sector before the 2008 recession. This change would mitigate QE’s effects on financial markets as well as return the Fed’s framework to a scarce-reserves regime. This would in turn strengthen the private borrowing market for reserves once again, allowing the federal funds rate to send a correct signal of borrowing conditions. The return to the scarce-reserves framework would have the added benefit of shielding the Fed’s independence from wanton government spending. Since monetary surpluses do have macroeconomic effects, particularly inflation, when reserves are scarce, Congress would no longer be able to use the Fed as a backdoor spending mechanism. To be fair, as Figure 1 shows, the Fed has attempted to reduce its asset holdings during periods of economic calm. However, the Fed has little incentive to wind up the QE purchases quickly for fear of inducing tighter credit conditions. Predictably, any additional economic disturbance further slowed the Fed’s pace for shrinking its balance sheet, and the temptation to implement new QE-style purchases has proven too great to resist. Consequently, the Fed should commit to not engaging in QE, even if there is external pressure to do so from financial market participants or elected officials. The Fed’s operations in the wake of the 2008 financial crisis gave rise to an experimental policy framework that replaced traditional market activity with bureaucratically administered interest rates. To shrink the Fed’s currently outsized footprint, thus restoring the market forces that the Fed has displaced, the Fed should shrink its balance sheet and end these experimental programs. To ensure that the Fed can no longer implement these types of lending programs in the future, Congress should restrict the Fed to purchasing only short-term US Treasury bonds. Additionally, Congress should limit the size of the Fed’s balance sheet. For example, Congress could cap the Fed’s total assets at no more than 10 percent of the commercial banking sector’s total assets, the approximate share held by the Fed prior to the 2008 financial crisis.[16](#_ednref16) These restrictions would make it harder for Congress to use the Fed for backdoor fiscal expenditures, and for the Fed to allocate credit beyond the banking sector. ## Conclusion The Federal Reserve has vastly expanded its footprint in financial markets through massive asset purchases. The size of the Fed’s balance sheet raises serious concerns about fiscal independence and financial stability. To maintain a clear demarcation between monetary and fiscal policy, as well as minimize the Fed’s footprint on financial markets, the Fed must trade only short-term US Treasury securities and revert to its pre-2008 policy framework. Congress should also limit the size of the Fed’s total assets relative to the size of the financial sector or outstanding federal debt. [![Reforming the Federal Reserve Full Cover](/sites/cato.org/files/styles/serial_cover_phone/public/2026-01/reforming-the-fed-full-book-cover.png?itok=z1Ghoblw)](https://www.cato.org/sites/cato.org/files/2026-01/Reforming-the-Federal-Reserve.pdf) ### Download This Publication ##### Reforming the Federal Reserve, Section 3: Restoring Sensible Asset Purchases [ Download PDF ](https://www.cato.org/sites/cato.org/files/2026-01/Reforming-the-Federal-Reserve.pdf) ##### About the Authors [![Norbert Michel Cropped](/sites/cato.org/files/styles/author_picture/public/2025-01/norbert-m-cropped.jpg?itok=8WIx97Dk)](/people/norbert-michel) ##### [Norbert J. Michel](/people/norbert-michel) Vice President and Director, Center for Monetary and Financial Alternatives, Cato Institute [ ](https://x.com/norbertjmichel) [![jai-kedia-cropped.jpg](/sites/cato.org/files/styles/author_picture/public/2023-07/jai-kedia-cropped.jpg?itok=In6dB8gW)](/people/jai-kedia) ##### [Jai Kedia](/people/jai-kedia) Research Fellow, Center for Monetary and Financial Alternatives, Cato Institute [ ](https://x.com/jaikedia) Show Endnotes Hide Endnotes ##### Notes [1](#_edn1). This section addresses the economic concerns caused by the assets side of the Fed’s balance sheet. Section 4 addresses the equivalent interest payment concerns stemming from the Fed’s liabilities. Of course, assets and liabilities are just two sides of the same coin. Any meaningful policy change would need reform on each side of the Fed’s balance sheet. [2](#_edn2). Agency MBS refers to MBS issued by Fannie Mae and Freddie Mac (both government-sponsored enterprises), or Ginnie Mae (a wholly owned US government corporation within the Department of Housing and Urban Development). [3](#_edn3). The idea is that the Fed’s purchases of longer-term securities will cause a portfolio balance effect, where investors tend to rebalance their portfolio away from the (safer) Treasury securities that the Fed’s purchases made scarcer to other (riskier) long-term assets. In theory, these riskier assets would now be purchased at higher prices, thus placing downward pressure on long-term interest rates. [4](#_edn4). For a critical appraisal of QE’s effectiveness, see Daniel L. Thornton, “[Requiem for QE](https://www.cato.org/policy-analysis/requiem-qe),” Cato Institute Policy Analysis no. 783, November 17, 2015. [5](#_edn5). Gara Afonso et al., “[Who’s Borrowing and Lending in the Fed Funds Market Today?](https://libertystreeteconomics.newyorkfed.org/2023/10/whos-borrowing-and-lending-in-the-fed-funds-market-today/),” *Liberty Street Economics* (blog), Federal Reserve Bank of New York, October 10, 2023. [6](#_edn6). Jai Kedia, “[Borrowing Rates Much Less Correlated with Fed’s Policy Rate](https://www.cato.org/blog/borrowing-rates-are-significantly-less-correlated-feds-policy-rate),” *Cato at Liberty* (blog), Cato Institute, October 24, 2024. [7](#_edn7). Esteban P. Caldentey, “[Quantitative Easing (QE), Changes in Global Liquidity, and Financial Instability](https://www.jstor.org/stable/48539963),” *International Journal of Political Economy* 46, no. 2/3 (Summer–Fall 2017): 91–112. [8](#_edn8). Jai Kedia, “[Fed’s Asset Purchases Result in Increased Market Volatility](https://www.cato.org/blog/feds-asset-purchases-result-increased-market-volatility),” *Cato at Liberty* (blog), Cato Institute, May 6, 2024. [9](#_edn9). In this context, “relatively short” refers to Treasury securities with a 5‑year maturity or less. Until 2008, roughly 80 percent of the Fed’s Treasury holdings were of such types, and the shares of under 90 days, 90-day to 1‑year, and 1‑year to 5‑year Treasury securities were relatively similar and constant. Since the 2008 crisis, the Fed’s holdings of Treasury bonds with a maturity of 1 year or less have shrunk below 20 percent of its assets. See Eric Milstein et al., “[What Does the Federal Reserve Mean When It Talks About Tapering?](https://www.brookings.edu/articles/what-does-the-federal-reserve-mean-when-it-talks-about-tapering/),” commentary, Brookings Institution, updated January 27, 2022. [10](#_edn10). These purchases also served as off-budget support (arguably, a bailout) of Fannie Mae and Freddie Mac, the two housing-finance giants that have remained in conservatorship since 2008, as well as financial institutions holding their securities. See Norbert Michel, “[The GSE Experiment Has Failed—Congress Should End It](https://www.cato.org/briefing-paper/gse-experiment-has-failed-congress-should-end-it),” Cato Institute Briefing Paper no. 180, October 14, 2024; and Steven Horwitz, “[An Introduction to US Monetary Policy](http://mercatus.org/publication/introduction-us-monetary-policy),” Mercatus Center at George Mason University, April 2, 2013. [11](#_edn11). Peter N. Ireland, “[Interest on Reserves: History and Rationale, Complications and Risks](https://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2019/5/cj-v39n2-5.pdf),” *Cato Journal* 39, no. 2 (Spring/​Summer 2019). [12](#_edn12). The yield curve is a chart showing the relationship between interest rates (bond yields) and the maturity lengths of bonds, typically US Treasurys. A normal curve slopes upward, indicating that investors need higher yields for longer maturities, while an inverted curve—where short-term rates exceed long-term rates—can signal expectations of economic slowdown or recession. [13](#_edn13). George Selgin, [*The Menace of Fiscal QE*](https://www.cato.org/books/menace-fiscal-qe) (Cato Institute, 2020). The Fed could even expand its deferred asset and remit funds directly to the Treasury without the ability to fall back on its price-stability mandate. See also Norbert Michel, “[Treasury’s $1 Trillion Coin and the Fed’s Magic Asset](https://www.forbes.com/sites/norbertmichel/2023/01/26/treasurys-1-trillion-coin-and-the-feds-magic-asset/),” *Forbes*, January 26, 2023. [14](#_edn14). Eric Leeper, “[Fiscal Dominance: How Worried Should We Be?](https://www.mercatus.org/research/policy-briefs/fiscal-dominance-how-worried-should-we-be),” Mercatus Center at George Mason University, April 3, 2023. [15](#_edn15). Ben S. Bernanke, “[The Federal Reserve’s Balance Sheet: An Update](https://www.federalreserve.gov/newsevents/speech/bernanke20091008a.htm),” speech, Federal Reserve Board Conference on Key Developments in Monetary Policy, October 8, 2009, Washington, DC, Board of Governors of the Federal Reserve System. [16](#_edn16). Alternatively, Congress could cap the Fed’s total assets at 10 percent of the share of total outstanding federal debt, the share it approximately was before 2008. [![Creative Commons License](/build/cato_2020/images/creative-commons.svg)](http://creativecommons.org/licenses/by-nc-sa/4.0/) This work is licensed under a [Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License](https://creativecommons.org/licenses/by-nc-sa/4.0/). [ Download PDF ](https://www.cato.org/sites/cato.org/files/2026-01/Reforming-the-Federal-Reserve.pdf)