Board of Governors of the Federal Reserve System
01/14/2026 | Press release | Distributed by Public on 01/14/2026 13:37
The Central Bank Balance-Sheet Trilemma
January 14, 2026
The Central Bank Balance-Sheet Trilemma
Burcu Dugyan-Bump and R. Jay Kahn
Introduction
Between December 2005 and December 2025, the Federal Reserve's balance sheet grew from about $800 billion to roughly $6.5 trillion-an increase from around 6 percent to 21 percent of GDP. This expansion primarily reflected two policy decisions by the FOMC. First, the FOMC introduced quantitative-easing programs after the Global Financial Crisis (GFC) and during the COVID-19 pandemic as a means of further lowering longer-term interest rates when targeted short-term interest rates were already at their effective lower bound.1 Second, the FOMC decided, in 2019, to make a structural shift in its operating framework for targeting short-term interest rates, moving to an ample-reserves regime for supplying liquidity to the banking system rather than returning to the scarce reserves regime that had been in place previously.2
Following the COVID-19 pandemic, the Federal Reserve began reducing the size of its balance sheet in June 2022 and concluded the process of balance-sheet reduction on December 1, 2025. And a few days later on December 10, the Federal Reserve announced it would begin reserve management purchases to maintain ample reserves. Looking ahead, the appropriate steady-state size of the balance sheet remains an open question, as there is no consensus among economists or policymakers on the issue.
In this note, we offer a framework for understanding the tradeoffs involved in determining the optimal size and behavior of a central bank's balance sheet. Specifically, we highlight that central banks face a "balance sheet trilemma," in that they can achieve only two of the following goals at once:
- a small balance sheet,
- low volatility of short-term rates, and
- limited market intervention.
The underlying tension between these goals arises from the financial sector's demand for reserves and the frequency of sudden changes in liquidity demand and supply.3 Figure 1 displays these options visually.
Figure 1. The balance-sheet trilemma visualized
Compromising on any of the three goals carries significant costs: 1) A large balance sheet increases the central bank's structural footprint in financial markets and could crowd out private sector credit intermediation. 2) High money-market volatility can dampen rate control, impeding the implementation of monetary policy and leading to unexpected funding stress and liquidity shortages. 3) Frequent market interventions expand the central bank's footprint through daily market operations, potentially impairing price discovery and market discipline. To be sure, the central bank can opt for an interior solution and tolerate some rate volatility (for instance, around calendar quarter-ends), some extra market operations, and a slightly larger balance sheet. But we hope the trilemma framework laid out here clarifies the tradeoffs central banks face.
The choice among these margins of adjustment is reflected in how and when the central bank supplies reserves, which has significant effects on markets. A large balance sheet whereby the central bank provides ample reserves helps banks absorb liquidity shocks, keeping rates stable. But a smaller balance sheet that makes reserves more scarce means that when shocks occur, either liquidity is rationed through frequent and sometimes large movements in short-term rates, or the effects of shocks must be mitigated by frequent central bank interventions. While in presenting the trilemma we focus on the Federal Reserve and its current operating framework, similar trade-offs have risen for foreign central banks and throughout the many different operating frameworks over the long history of the Fed, including the reserve-scarcity regimes before 2008 and the ample-reserves environment today.4
The origins of the trilemma
The steady-state size of a central bank's balance sheet matters because its assets back key liabilities, especially bank reserves. Banks hold reserves as a buffer to meet settlement obligations and internal liquidity needs.5 As this buffer shrinks, pressures build in money markets and spreads - that is, the relative costs of liquidity - rise, reflecting the higher compensation banks require to part with scarce liquidity.6 To offset these pressures and maintain control of short-term interest rates, the central bank can conduct active open market operations, adjusting its asset holdings to supply or absorb reserves. It can also use passive tools, such as, in the U.S. case, the Federal Reserve's Standing Repo (SRP) operations, Overnight Reverse Repo (ON RRP) operations, and the Discount Window that allow reserves to rise or fall in response to market demand.
The challenge is that liquidity conditions are subject to sudden changes, which arise from movements in both supply and demand for reserves. For example, in the particular U.S. case, on the supply side, changes in the Treasury General Account (TGA), the ON RRP, and the foreign repo pool mechanically alter the level of reserves provided by the Fed. Increases in these liabilities reduce reserves one-for-one and tighten conditions unless the increases are offset by the Fed. On the demand side, reserve needs can spike due to large payment flows, quarter-end balance-sheet effects, or natural disasters. Some of these movements are predictable, such as scheduled TGA swings due to tax payments, while others are inherently uncertain.
As illustrated in Figure 2, these sudden changes have larger effects on money-market rates when the balance sheet is smaller.7 In the figure, modest changes in liquidity conditions (blue) generate pronounced rate movements (red) at lower reserve levels. When reserve buffers are thin, banks face a higher risk of falling short on settlement. Any reduction in reserves or increase in liquidity demand forces banks to give up part of an already minimal cushion, and they demand significant compensation to do so. Consequently, even small shocks can translate into outsized increases in short-term funding rates across markets.8
Figure 2. Reserve demand and money market rate volatility
Figure 3 shows this mechanism in action in the context of the U.S. repo market. Following Gissler et al. (2025), the left panel shows that as reserves fall, the spread of the Tri-Party General Collateral Rate (or TGCR, a measure of broad repo rates) to the ON RRP rate becomes increasingly responsive to movements in the TGA, one prominent driver of liquidity conditions. A similar relationship exists with sensitivity to other sudden, large changes in liquidity supply and demand like Treasury issuance (Cordes et al., 2025), quarter-ends (Bostrom et al., 2025) and balances in the foreign repo pool (Alquist et al., 2022): In each case, TGCR sensitivity rises as reserve fall relative to outstanding Treasuries. These data patterns illustrate the tradeoffs posed by the trilemma: with fewer reserves, rate sensitivity rises, and, as a consequence, volatility will rise absent central bank intervention, consistent with the pattern in the right panel of Figure 3.
Figure 3. Repo rate sensitivity and volatility vs. normalized reserves
Notes: Data are weekly. Both series use spreads of the TGCR over the ON RRP rate. Data for the week of September 17, 2019 and the month of March 2020 are dropped. Volatility is the 90-day rolling standard deviation of the spread, sensitivity is a rolling OLS regression of the change in the spread on the change in the Treasury General Account (TGA), using the same methodology as Gissler et al. (2025).
Sources: Federal Reserve Bank of New York Reference Rates, H.4.1. Factors Affecting Reserves, TreasuryDirect
These dynamics lead directly to the balance-sheet trilemma. As its balance sheet shrinks, the central bank must choose which goals to pursue most aggressively: It can tolerate greater interest-rate volatility, or it can maintain rate stability by actively adjusting its asset holdings in response to shocks. Achieving both low volatility in rates and limited market intervention is possible only with a larger steady-state level of reserves. Put simply: a small balance sheet forces either volatile rates or frequent central bank operations; avoiding both requires a larger balance sheet.
Costs of the trilemma and implications for the central bank's footprint
The trilemma highlights that a central bank must decide to what extent changes in liquidity will be absorbed through its balance-sheet size, managed through frequent market interventions, or allowed to lead to rate volatility. Each choice entails a distinct set of costs and shows that the central bank will almost always have a footprint, but the nature of that footprint will be determined by the choices made in the context of the trilemma.
A large balance sheet allows the private sector to absorb liquidity shocks using a large cushion of safe and liquid assets, thereby preventing volatility in short-term rates without the need for regular intervention by the central bank. In addition, provision of reserves enhances financial stability by providing a safe public asset that financial market participants can hold instead of private money-like assets that can create run risk in the system.9
However, a large balance sheet, whereby the central bank provides a lot of reserves, can crowd out private sector money market activity such as inter-bank lending or money market fund lending to dealers. As a result, a large balance sheet potentially reduces price discovery for short-term rates, weakens market discipline, and may deprive markets of the information that could be provided by a active inter-bank market.10
Moreover, a large balance sheet often creates duration risk as longer-term securities holdings by the central bank are financed with shorter-term (often overnight) liabilities. When interest rates rise, this generates mark-to-market losses and higher costs for remunerating reserves (interest on reserve balances, IORB) and ON RRP balances, leading to lower-and potentially negative-remittances to the Treasury.
High volatility of short-term rates implies a system where a small quantity of reserves are rationed through movements in market rates without any regular central bank intervention. Over time, this may force market participants to adapt to liquidity pressures and reduce leverage.
However, high volatility in short rates can weaken the central bank's control over interest rates and complicate monetary transmission. When short-term rates fluctuate for reasons unrelated to policy or fundamentals, funding costs for banks and firms become less predictable, potentially creating frictions in payment-system functioning and making it harder to plan investments. Persistent volatility can also spill over to longer maturities, as investors demand higher term premiums to compensate for short-rate uncertainty. Over time, this can weaken the link between the policy rate and broader financial conditions.
In extreme cases, high volatility of short-term rates can have financial stability consequences. In the short run, sharp rate swings can disrupt leveraged investors that rely on stable short-term funding, although these investors may adjust their behavior if volatility persists as a regular feature of the environment.11
In Figure 4, we highlight how short-term rate volatility has changed over time in the U.S. fed funds market. This figure shows how the Fed operated with varying levels of rate volatility under different implementation regimes-higher rate volatility in an era of scarce reserves and frequent daily interventions followed by the very low rate volatility during the ample reserves regime.
Figure 4. Fed funds spread volatility and reserves
Notes: Prior to December 16, 2008 fed funds spread is the spread of the effective federal funds rate to the fed funds target. After this date, fed funds spread is the spread to the midpoint of the target range. For reserves, we use monthly H.6. data prior to December 18, 2002 and weekly H.4.1. data since then.
Sources: H.15 Selected Interest Rates, H.4.1. Factors Affecting Reserves, H.6 Money Stock Measures.
Frequent market intervention implies a regime of daily operations-including through standing facilities-where timely interventions would, in principle, curb money-market volatility by adding reserves when pressures arise yet allow the central bank to operate with a leaner average reserve supply in normal times.
The costs of frequent interventions depend on whether they are implemented through active open-market operations or passive standing facilities.12 Active open market operations require continual assessment of the amount of reserves needed to respond to shifting liquidity conditions. Anticipated changes-such as large Treasury settlements-may be straightforward to offset, but unanticipated or uncertain shocks-like changes in foreign official liquidity demand, large margin calls that require the financial sector to provide more cash, or natural disasters-are harder to gauge. Misjudging the direction or magnitude of these shocks can amplify, rather than smooth, rate movements.13
Alternatively, the central bank can rely more heavily on passive open market operations, such as the Fed's SRP operations and ON RRP operations to place ceilings and floors, respectively, on market rates. This approach reduces the need for active intervention and allows the balance sheet to fluctuate endogenously, providing just the amount of reserves necessary to satisfy demand at rates within the target range. However, a potential drawback is that frequent use of these operations might lead to weakening of market discipline and distortion of market signals - concerns that are similar to those associated with a large balance sheet.14
Conclusion
In this note, we offer a framework for understanding the tradeoffs involved in determining the optimal size and behavior of a central bank's balance sheet by highlighting that central banks face a balance-sheet trilemma: they can simultaneously achieve only two of the following-a small balance sheet, low short-term rate volatility, and limited intervention in money markets.
We note that each option carries its own costs. A larger balance sheet stabilizes rate control and reduces the need for intervention but expands the central bank's structural footprint. A smaller balance sheet limits that footprint yet either requires more active liquidity management or tolerates greater rate variability. No operating regime can simultaneously achieve all three goals.
Bibliography
Gara Afonso, Gonzalo Cisternas, Brian Gowen, Jason Miu, and Josh Younger, 2023a. "Who's Borrowing and Lending in the Fed Funds Market Today?" Liberty Street Economics 20231010, Federal Reserve Bank of New York.
Gara Afonso, Kevin Clark, Brian Gowen, Gabriele La Spada, JC Martinez, Jason Miu, and Will Riordan, 2024. "A New Set of Indicators of Reserve Ampleness." FRBNY Liberty Street Economics, August 14.
Gara Afonso, Gabriele La Spada, Thomas M. Mertens, and John C. Williams, 2023b. "The Optimal Supply of Central Bank Reserves under Uncertainty." Working Paper Series 2023-34, Federal Reserve Bank of San Francisco.
Sriya Anbil, Alyssa Anderson, Romina Ruprecht, and Ethan Cohen, 2024. "Stop Believing in Reserves", SSRN Working Paper, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4834559.
Sriya Anbil, Sebastian Infante, and Zeynep Senyuz, 2025. "A Tale of Demand and Supply for Central Bank Reserves," Working Paper.
Adrien d'Avernas, Baiyang Han, and Quentin Vandeweyer, 2025. "Intraday Liquidity and Money Market Dislocations." Management Science 0(0).
Andrew Bailey, 2024. "The Importance of Central Bank Reserves." Lecture at the London School of Economics in honor of Charles Goodhart, May 21, 2024.
Daniel Barth and R. Jay Kahn, 2025. "Hedge Funds and the Treasury Cash-futures Basis Trade." Journal of Monetary Economics, Elsevier, vol. 155(C).
Erik Bostrom, David Bowman, Amy Rose, and Andy Xia, 2025. "What Happens on Quarter-Ends in the Repo Market," FEDS Notes 2025-06-06-1, Board of Governors of the Federal Reserve System (U.S.).
Michelle Bowman, 2025. "Thoughts on Monetary Policy Decisionmaking and Challenges Ahead," Speech at the Forecasters Club of New York Luncheon, September 26, 2025.
W. Randolph Burgess, 1936. The Reserve Banks and the Money Market, New York: Harper and Brothers Publishers
Mark Carlson, Burcu Duygan-Bump, Fabio Natalucci, Bill Nelson, Marcelo Ochoa, Jeremy Stein, and Skander Van den Heuvel, 2016. "The Demand for Short-Term, Safe Assets and Financial Stability: Some Evidence and Implications for Central Bank Policies." International Journal of Central Banking, December.
James A. Clouse, Sebastian Infante and Zeynep Senyuz, 2025. "Market-Based Indicators on the Road to Ample Reserves." FEDS Notes 2025-01-31-1, Board of Governors of the Federal Reserve System (U.S.).
Adam Copeland, Darrell Duffie and Yilin Yang, 2022. "Reserves Were Not so Ample After All." Federal Reserve Bank of New York Staff Report No. 974, Federal Reserve Bank of New York, New York.
Lucy Cordes and Sebastian Infante, 2025. "Repo Rate Sensitivity to Treasury Issuance and Quantitative Tightening." FEDS Notes 2025-02-12-1, Board of Governors of the Federal Reserve System (U.S.).
Ben R. Craig and Sara E. Millington. 2017. "The Federal Funds Market since the Financial Crisis." Federal Reserve Bank of Cleveland, Economic Commentary 2017-07.
Darrell Duffie, 2025. "Liquidity Rules Have Increased the Minimum Size of the Fed's Balance Sheet." in Getting Global Monetary Policy Back on Track, edited by Michael Bordo, John Cochrane, and John Taylor, Hoover Press, 2025, Chapter 11, pp. 179-187.
Huberto M. Ennis, Arantxa Jarque, and Hoossam Malek, 2022. "Bank Resolution and the Fed's New Standing Repo Facility." Richmond Fed Economic Brief, Federal Reserve Bank of Richmond, vol. 22(06), February.
Josh Frost, Lorie Logan, Antoine Martin, Patrick E. McCabe, Fabio M. Natalucci, and Julie Remache, 2015. "Overnight RRP operations as a monetary policy tool: some design considerations." Staff Reports 712, Federal Reserve Bank of New York.
Toni Gravelle, 2025. "The End of Quantitative Tightening and What Comes Next." Remarks at VersaFi, January 16, 2025.
Stefan Gissler, Samuel J. Hempel, R. Jay Kahn, Patrick E. McCabe and Borghan N. Narajabad, 2025. "Monitoring Reserve Scarcity Through Nonbank Cash Lenders." FEDS Notes 2025-03-28-4, Board of Governors of the Federal Reserve System (U.S.).
Song Han, Kleopatra Nikolaou, and Manjola Tase, 2022. "Trading Relationships in Secured Markets: Evidence from Triparty Repos." Journal of Banking & Finance, Elsevier, vol. 139(C).
Samuel J. Hempel, Calvin Isley, R. Jay Kahn, and Patrick E. McCabe, 2023. "Money Market Fund Repo and the ON RRP Facility." FEDS Notes 2023-12-15-2, Board of Governors of the Federal Reserve System (U.S.).
Charles M. Kahn, Stephen F. Quinn, and William Roberds, 2023. "The Fed and Its Shadow: A Historical View." Policy Hub, Federal Reserve Bank of Atlanta, vol. 2023(6), pages 1-32, October.
Christopher Kent, 2025. "The RBA's Monetary Policy Implementation System-Some Important Updates." Remarks at KangaNews Debt Capital Markets Summit, April 2, 2025.
John Larkin, Elizabeth Frayne and Anne-Marie McKiernan, 2024. "The Evolution of the Eurosystem Operational Framework and How Recent Changes May Impact Banks in Ireland." Central Bank of Ireland Quarterly Bulletin 04, December 2024.
Lorie Logan, 2025. "Opening Remarks for Panel Titled 'Post-Pandemic Challenges for Monetary Policy Implementation.'" Remarks at the Conference on the Future of Central Banking at Banco de Mexico, August 25, 2025.
David Lopez-Salido and Annette Vissing-Jorgensen, 2025. "Reserve Demand, Interest Rate Control, and Quantitative Tightening." SSRN Working Paper, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4371999
Stephen Miran, 2025. "Regulatory Dominance of the Federal Reserve's Balance Sheet." Speech at the Bank Policy Institute and Small Business and Entrepreneurship Council, Washington, D.C.
Jeffrey Miron, 1986. "Financial Panics, the Seasonality of the Nominal Interest Rate, and the Founding of the Fed." The American Economic Review, 76(1), 125-140.
Bill Nelson, 2024. "How the Federal Reserve Got so Huge and Why and How It Can Shrink," BPI Staff Working Paper 2024-1.
Bill Nelson, 2025. "Forward Guidance: Remodeling the House After Tearing Up the Floor: Suggestions for the Fed's Implementation Framework," LinkedIn post, https://www.linkedin.com/pulse/forward-guidance-remodeling-house-after-tearing-up-floor-bill-nelson-u0omc/
Roberto Perli, 2025, "Money Market Conditions and the Federal Reserve's Balance Sheet," remarks at the 2025 U.S. Treasury Markets Conference, November 12, 2025.
William Poole. 1970. "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model." Quarterly Journal of Economics 84, no. 2 (May): 197-216.
Victoria Saporta, 2024. "Let's Get Ready to Repo!" Speech at the Association for Financial Markets in Europe, July 22, 2024.
Annette Vissing-Jorgensen, 2025. "Fluctuations in the Treasury General Account and their effect on the Fed's balance sheet," FEDS Notes 2025-08-06, Board of Governors of the Federal Reserve System (U.S.).
Christopher Waller, 2025. "Demystifying the Federal Reserve's Balance Sheet," speech at the Federal Reserve Bank of Dallas.
John Williams, 2025. "On the Optimal Supply of Reserves," remarks at the New York Fed-Columbia SIPA Monetary Implementation Workshop, May 22, 2025.
1. The asset purchases during COVID-19, especially early on in the pandemic, were also intended to support smooth market functioning and the effective transmission of monetary policy to broader financial conditions. Return to text
2. To be sure, other liabilities, including currency and the Treasury general account, have also grown and contributed to the overall growth of the Fed's balance sheet, Meanwhile, regulatory changes, including liquidity rules introduced after the 2008 GFC, have contributed to increased demand for reserves by banks, as highlighted by Duffie (2025), Miran (2025) and Nelson (2024). Return to text
3. This echoes Williams (2025), who states that the "key building block… is that the demand for central bank reserves is inherently nonlinear and subject to uncertainty." Return to text
4. For example, Burgess (1936) outlines similar links between changes in reserves and money market rates under scarce reserve conditions, while noting "Under [large excess reserves] small gains or losses of funds have had practically no effect" on rates. Thus, the core elements of the balance-sheet trilemma were relevant at this earlier stage of the Fed's development. For related issues at other central banks see Saporta (2024), Larkin et al. (2024), Gravelle (2025) and Kent (2025). Return to text
5. See, for instance, Copeland et al. (2022). Return to text
6. See Afonso et al. (2024), Clouse et al. (2025) and Gissler et al. (2025), for examples of recent research linking money market spreads to reserve conditions. Return to text
7. This figure is essentially identical to Clouse et al. (2025), and the relationship between reserve scarcity and money market volatility is common to many models of monetary policy transmission such as Anbil et al. (2024), d'Avernas et al. (2025) and Lopez-Salido and Vissing-Jorgensen (2025). Return to text
8. See Copeland et al. (2022). Return to text
9. See for instance Carlson et al. (2016). Return to text
10. For instance, interbank activity in the federal funds market fell dramatically with the expansion of the Federal Reserve balance sheet following the 2008 financial crisis, see Craig and Millington (2017) and Afonso et al. (2023a). Similarly, Frost et al. (2015) consider crowding out of private repo activity as a potential consequence of ON RRP operations. On the value of information produced by an inter-bank market, see Bowman (2025), Gissler et al. (2025) and Anbil et al. (2025). Return to text
11. This argument is made by Perli (2025). Barth and Kahn (2025) argue that spikes in repo rates in fact contributed to sales by hedge funds in the cash-futures basis trade during March 2020. Return to text
12. For a discussion of "active" and "passive" components of monetary policy, see Kahn et al. (2023). These two options bear some relation to the older arguments over interest rate instruments and reserve instruments, see Poole (1970). For modern examples, Nelson (2025), Waller (2025), and Vissing-Jorgenson (2025) propose using open market bill or repo purchases to actively counteract movements in liabilities like the TGA account, while Logan (2025) contemplates relying more on SRP operations to control rates in the U.S. as reserves decline and Saporta (2024) emphasizes the centrality of regular use of the BoE's Short-Term Repo facility in the U.K. Return to text
13. For example, Afonso et al. (2023b) use the uncertain demand for reserves as an argument for greater reserve abundance. Return to text
14. For instance, see the arguments in Bowman (2025) and Ennis et al. (2022). Return to text
Please cite this note as:
Dugyan-Bump, Burcu, and R. Jay Kahn (2025). " The Central Bank Balance-Sheet Trilemma," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, January 14, 2026, https://doi.org/10.17016/2380-7172.3979.
Board of Governors of the Federal Reserve System published this content on January 14, 2026, and is solely responsible for the information contained herein. Distributed via Public Technologies (PUBT), unedited and unaltered, on January 14, 2026 at 19:38 UTC. If you believe the information included in the content is inaccurate or outdated and requires editing or removal, please contact us at [email protected]