Fed Anxiety Rises as QE Increases Risk of Loss With CostsCaroline Salas Gage and Joshua Zumbrun
The longer the Federal Reserve continues its bond-buying stimulus, the higher the odds it will face a year without any money to give the U.S. Treasury after taxpayers received a record $88.4 billion profit in 2012.
The Fed’s financial-crisis actions -- from acquiring debt in the 2008 rescues of Bear Stearns Cos. and American International Group Inc. to three rounds of quantitative easing -- have led so far to the record payments. Now, the prospect of a stronger economy and rising interest rates means the value of the Fed’s bond holdings will fall at the same time its funding costs climb because the central bank pays interest on the excess reserves it holds for banks.
This could cause operating losses and invite increased scrutiny from lawmakers already critical of the central bank’s policies.
That’s a risk central bankers are grappling with as they consider when to slow the $85 billion monthly pace of their government and mortgage-backed securities purchases. Federal Reserve Bank of New York President William C. Dudley said in a speech last month that the central bank’s balance-sheet expansion does “create some budget risk” that threatens the institution’s independence.
“They’ve done a few things to try to insulate themselves from this concern, but I suspect in the back of their minds it still haunts them,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. “It’s not going to go away.”
Dudley said Oct. 15 in Mexico City that the Fed’s “traditional monetary-policy framework” has helped assure the central bank’s budget independence and thus support its overall independence. A “key question” is how unconventional measures that have ballooned the central bank’s balance sheet to a record $3.85 trillion may have threatened that status, he said.
“The Fed is a lightning rod: It attracts withering criticism from the Republican base,” said Greg Valliere, chief political strategist at the Potomac Research Group in Washington. “So even after several years of turning huge profits over to Treasury, losses would embolden the Fed-haters.”
The Fed receives interest payments on its holdings of government securities and mortgage debt. It uses this and other income for the operations of its board of governors and 12 regional reserve banks, returning the remainder to the Treasury, where the funds are added to the department’s total receipts.
The prospect of no remittances prompted questions earlier this year from Republican lawmakers. Central bank losses are “a legitimate concern and something we will be watching,” Representative John Campbell of California said in an interview in February. He leads a monetary-policy subcommittee of the House Financial Services Committee.
Federal Reserve Bank of Atlanta President Dennis Lockhart said today that the central bank will consider reducing the pace of its bond buying at next month’s policy meeting.
“I would not take off the table at least consideration at that time,” Lockhart told reporters in Oxford, Mississippi, in response to a question. “The question of changing the mix of accommodative tools ought to be on the table at every meeting for the foreseeable future.”
Historically, the Fed didn’t have to use any of its interest income to fund its assets because it didn’t pay interest on the cash banks put on deposit. In 2008, the Fed gained the ability to pay interest on these reserves -- a tool it plans to rely on to tighten policy and keep its bloated balance sheet from spurring inflation. The rate is currently 0.25 percentage point.
As the Fed’s balance sheet grows, so do total excess reserves because under QE, policy makers direct the markets desk at the New York Fed to buy securities from primary dealers, or brokers who are authorized to trade directly with the central bank. That adds funds to the dealers’ accounts and creates reserves at their clearing banks, increasing the amount of money the Fed will have to pay interest on.
“If the balance sheet expands further from here, the possibility of a loss becomes more and more real,” said Roberto Perli, a partner at Cornerstone Macro LP in Washington and a former Fed economist.
At the current balance-sheet level, an interest rate of 4.9 percent would be sufficient to wipe out the Fed’s income, according to Perli’s calculations. If the balance sheet grows for another year, the rate that causes interest on reserves to produce a loss falls to 4.3 percent.
“It’s not dangerous yet, but it’s getting there,” said Perli. That’s because, in the longer-run, most Fed officials see their target rate rising to 4 percent.
Fed policy makers have tried to address the prospect for losses from the bond holdings themselves by abandoning a plan to sell mortgage-backed securities as part of their eventual exit strategy.
Chairman Ben S. Bernanke said in June the central bank would hold on to the debt after Fed economists led by Seth Carpenter, a senior associate director in the Board’s Division of Monetary Affairs, said in a January paper that the institution was on course to lose an unprecedented amount of money and might be unable to remit a profit to the Treasury for as long as six years.
Carpenter updated his paper and estimates in September to reflect the decision not to sell mortgage bonds. He found the central bank can continue to have earnings by never selling these securities -- as long as the benchmark federal funds rate gradually climbs from near zero to 4 percent by 2018, with the yield on the 10-year Treasury note slowly rising to about 5 percent from 2.6 percent at 4:59 p.m. yesterday in New York, according to Bloomberg Bond Trader data.
Under a higher-interest-rate scenario -- where 10-year Treasury yields climb 3 percentage points by the end of 2016 -- the Fed doesn’t remit any money to the Treasury from 2017 to 2019 if it refrains from selling any bonds, and has no money to pass on for six-and-a-half years if it does sell securities, the Carpenter paper shows. The Fed accounts for a loss as a “deferred asset.”
“It feels like they’ve tried to convince themselves this isn’t a problem, in part because they came up with this deferred-asset way of looking at operating losses and because they switched to a no-asset-sale approach,” said Feroli, a former Fed Board economist. “As you add up really big numbers, it does start to creep back into their thinking.”
Dudley said Oct. 15 that while “this risk is real,” it is “not a big threat” because rates would have to “rise appreciably” for losses to occur.
Also, “we should take a long-term perspective,” reflecting the Fed’s elevated remittances of about $80 billion annually “in recent years,” compared with $20 billion to $30 billion before the financial crisis, Dudley said.
Four economists including Frederic Mishkin, a former Fed governor and co-author with Bernanke, said in a paper presented in New York on Feb. 22 that the central bank’s grip on policy may weaken if losses coincide with high U.S. budget deficits and an inability of Congress and the White House to put fiscal policy on a sustainable path.
“This mix could induce a bias toward slower exit or easier policy and be seen as the first step toward fiscal dominance,” the economists said in the paper, written for the U.S Monetary Policy Forum, referring to fiscal influence on monetary policy. “It could thereby be the cause of longer-term inflation expectations and raise the risk of inflation overall.”
While deciding against selling mortgage debt leads to more stable profits, the strategy change would mean the central bank’s balance sheet wouldn’t return to normal for the foreseeable future, according to the Fed economists. Even by 2025 -- almost two decades after the housing bubble that precipitated the financial crisis began to burst -- the Fed still would own $407 billion in mortgage bonds.
The Carpenter projections assume the Fed pares the pace of its bond purchases in December and finishes the program in June.
Economists expect quantitative easing to go on for longer. The Fed won’t begin tapering its bond buying until March and will continue purchasing securities until October, according to the median estimate of 40 analysts in a Bloomberg News survey last month.
“The right way to think about it is -- what were the economic gains or benefits associated with the way the Fed manages the portfolio?” said Robert Shapiro, chief executive officer of Sonecon LLC, an economic advisory firm in Washington.
“Congress will ask about all these losses, if taxpayers will be on the hook? Well, taxpayers are on the hook for interest payments that rise with other interest rates, but that’s always the case,” said Shapiro, a former Commerce Department official under President Bill Clinton.
“Will they demand an accounting from Janet Yellen?” he said, referring to the Fed vice chairman, who was nominated by President Barack Obama to succeed Bernanke when his term ends Jan. 31. “They certainly could.”