After helping keep the U.S. banking system afloat, is the Federal Reserve about to lose a fortune on its own bond purchases?
If you listen to opponents of Fed policy, you might think that the large expansion of its balance sheet -- from assets of less than $1 trillion in 2007 to more than $3 trillion today -- will result in it hemorrhaging money, draining the Treasury and disrupting monetary policy. Calm down: While the Fed may have to book a loss, catastrophe will not follow. Such an accounting item would be a small price to pay for the Fed's vital stimulative efforts.
Here's the situation: Should the labor market improve or inflation perk up, we can expect the Fed to reverse its current expansionary policy of $85 billion worth of mortgage-backed securities and Treasury debt purchases a month. It may also increase the funds rate. If so, the Fed would probably take losses on its securities sales and not be able to remit money to the Treasury.
(Normally, the Fed is able to pay for its own operations and then send the leftover money from interest payments on the debt portfolio the Treasury. In the five years before the financial crisis, these remittances totaled $157 billion. In the past four years, the Fed has transferred $291 billion.)
Yet the Fed, even though it creates the bank reserves used to purchase bonds, can still book losses. It realizes capital gains or losses only when an asset is sold. Since the Fed may sell off its $1 trillion-plus portfolio of mortgage-backed securities after interest rates rise, it will more than likely book a loss, because it bought bonds when rates were low (and prices high) and will be selling them when prices are low and rates are high (the Fed might just hold on to them, rendering this whole discussion moot). Depending on how much interest rates rise, the Fed would book a “deferred asset” if the losses swamped the interest income from the rest of its portfolio. The Fed would then have to earn back the amount of the deferred asset before it restarted payments.
So, is this a problem? Politically, perhaps. A paper by former Fed governor Frederic Mishkin and three co-authors projects that the Fed could take about $20 billion in losses and remit nothing back to the Treasury for about three years during its exit. Mishkin and his co-authors say that a loss and cessation of payments to the Treasury “could bring Fed policy decisions under greater public scrutiny, potentially leading to controversy that could even threaten central bank independence.” Some current and former Fed officials have voiced similar sentiments. An analysis by the Fed itself also projects remittances halting for as long as four years, with the Fed booking a deferred asset worth $45 billion.
But Fed Chairman Ben S. Bernanke and Vice Chairman Janet Yellen have argued in congressional testimony and speeches that even if remittances go to zero, it won’t negatively affect monetary policy or the fiscal stance of the Treasury for two reasons: because remittances have been so high recently, and because the asset purchases themselves have improved the economy. The same Fed analysis that projects a deferred asset of $45 billion also projects cumulative remittances of $720 billion between 2009 and 2025.
Yellen said in a recent speech that “balance sheet operations are intended to support economic growth and job creation in a context of price stability and not to maximize Federal Reserve income.” This is the statutory mandate the Fed works under: to maximize employment and maintain low and stable inflation. Right now, inflation is below the 2 percent target, leaving room for the Fed to stimulate. If the Fed is right, and its easing policies have brought down long-term interest rates and will lead to higher growth and job creation, then it should continue with the easing, future losses be damned.
It’s no coincidence that many of those concerned with the Fed booking a loss are skeptical of its current policy. Representative Jim Jordan, a Republican from Ohio, wrote a letter to Bernanke demanding information and documents from the Fed on future losses. Representative John Campbell of California told Bloomberg News, in reference to accounting for losses as a deferred asset, “I don’t think we will buy that,” and that Fed losses are “a legitimate concern and something we will be watching.”
While the Fed must be careful that its actions don’t lead Congress to clamp down on its independence, it shouldn’t worry about whether congressmen “buy” its accounting. It should focus on what American households and business are buying. And if stimulating growth means losses down the road, when the economy is growing and interest rates can rise again, the public might buy that, too.
(Matthew Zeitlin is a contributor to the Ticker. Follow him on Twitter.)