If you follow financial news, you may have noticed headlines about the Federal Reserve's balance sheet and how the agency is working to reduce its size. This may sound odd at first -- after all, isn't a balance sheet a concept that's generally associated with a business?

If you're confused about what the Fed's balance sheet is, why it's so big, and why the market cares about what the Fed does with it, don't worry: The concepts behind the Fed's balance sheet are generally easy to understand. Here's a basic explanation of how it works.

Magnifying glass over a balance sheet.

Image source: Getty Images.

What is the Fed's balance sheet?

When you hear about the Federal Reserve's balance sheet, know that it refers to the same concept as any other use of the term balance sheet in finance -- an accounting of an organization's assets and liabilities. Most of the Fed's assets are in the form of U.S. Treasury securities and mortgage-backed securities, or MBS. Its liabilities are mainly U.S. currency (Federal Reserve notes are a liability for the Federal Reserve) and any reserve deposits held on behalf of other financial institutions.

While the exact composition of the Fed's balance sheet changes over time, the Fed had $3.97 trillion in assets as of March 13, 2019. Roughly 55% of that was is in Treasury securities (all notes and bonds, not bills), while about 40% was in MBS.

The Federal Reserve's balance sheet total has ballooned in size over the past decade or so, rising from about $870 billion in mid-2007 to a peak of more than $4.5 trillion in early 2015.

How did the Fed end up with trillions in assets?

The simple answer is that the Fed's balance sheet was far less complicated before the 2008-2009 financial crisis. In an effort to help stimulate the U.S. economy and support the subsequent recovery, the Fed decided to purchase large amounts of securities. This was in addition to keeping interest rates near zero until late 2015.

The actual buying activity took different forms over the post-crisis years. For example, beginning in September 2012, the Federal Open Market Committee (FOMC, which is the policy-making arm of the Federal Reserve) decided to purchase agency-guaranteed MBS at a $40 billion monthly pace. Then, $45 billion in monthly long-term Treasury security purchases were added in January 2013. In 2014, as the economy strengthened, the asset purchases were gradually reduced and finally stopped altogether in October 2014.

The plan to get the balance sheet back to normal

Most economists agree that a normal Federal Reserve balance sheet is significantly smaller than $4.5 trillion. There's no specific right amount, but for context, remember that the balance sheet was less than $1 trillion before the crisis began.

So, as the health of the U.S. economy improved in the post-crisis era, the Fed announced a plan to reduce the size of its balance sheet. This process is referred to as normalization.

In October 2017, the FOMC announced that it would begin selling assets at a gradually increasing rate for the foreseeable future, up to an eventual maximum of $50 billion per month. By March 2019, the balance sheet had fallen by about $500 billion -- a significant reduction.

However, with data indicating that the U.S. economy may be slowing down, the Fed recently decided to slow down its normalization plan. Beginning in May 2019, the reduction rate will be just $15 billion per month (about half the prior rate) until September 2019, when it will be put on hold.

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Why the market cares

Here's why you've seen this subject in the news so much recently. While the ultimate goal is to shed trillions from the balance sheet, it's extremely important to the overall economy that it happen in a controlled and careful manner.

The Fed can't simply sell off trillions of dollars' worth of assets at once without causing economic ripples. Doing so would flood the market with Treasuries and other fixed-income securities and could threaten the overall stability of the economy. Just as the purchase of securities by the Fed helped inject money into the economy -- a form of stimulus -- the reduction of the balance sheet is essentially taking money out of the economy.

While the economy was steadily improving, lowering the asset total made good financial sense. But indicators in early 2019 show the economy may be starting to cool off. There's widespread concern that continuing to wind down the balance sheet could make any economic slowdown worse and could even throw the U.S. into recession.