Despite the all Fed talk about shrinking its balance sheets, many observers are hoping the Fed keeps it large. They want the Fed to maintain a large balance sheet for various reasons: it earns a positive return for the government; it provides a financial stability tool via provisions of safe assets; it needs to remain big and accommodative until the economy really starts roaring. There are also complications to shrinking the Fed balance sheet. Whatever you make of these arguments they all ignore an important political-economy consideration: a large Fed balance sheet makes for bad optics because of interest paid on excess reserve (IOER). The figure below explains why. Using data from the Federal Reserve's H8 report, the figure shows the cash assets of "large
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Think about the implications: the banks that were bailed out during the crisis and the banks owned by foreigners are getting most of the IOER payment. This is a perfect storm of financial villains for both the political left and the right. That is why I agree with Ramesh Ponnuru that it politically naive to think the Fed can maintain a large balance.