An important discussion that's been simmering in monetary policy circles for some time is starting to come to a boil: Will the Federal Reserve, a few years down the road, be staring at massive losses on the multitrillion-dollar portfolio of bonds it has acquired in its unconventional efforts to prop up the nation's economy?
Here’s how it works: The Fed has been buying securities, using newly created dollars, to push down longer-term interest rates and flood the economy with money -- all to spur growth. It now owns $1.7 trillion in Treasury bonds and $1 trillion in mortgage-backed securities and is adding to that at a rate of $85 billion a month, with the end date uncertain. (The bond purchases are known as quantitative easing, or QE.)
The Fed earns interest on those holdings and returns that income (minus its operating expenses) to the U.S. Treasury every year. The central bank returned a record $89 billion to taxpayers in 2012, from interest income.
So far, so good. The Fed doesn’t set policies to try to maximize its profits; rather, its earnings are a happy byproduct of having a license to print money (the technical term is seigniorage). Even so, the central bank could find itself in the political line of fire. The Fed does what it thinks it needs to do to lower unemployment and keep inflation stable, and the taxpayer ends up better off. The problem could come down the road.
Eventually, the Fed will likely need to shrink its balance sheet and/or raise interest rates to undo its easy money policies and prevent inflation from getting out of control. And when that day comes, the Treasury bonds and mortgage securities it owns will probably be worth less (when interest rates are higher, the old securities with low interest rates become less valuable).
So, suddenly, instead of being the most profitable bank in the land, the Fed could find itself with much less income to return to the Treasury, and maybe with no income at all. (There are even remote scenarios in which the Fed could lose so much money on its portfolio that it would need to be recapitalized with an infusion from Congress). In the most simplistic term, just as the Fed made big profits for pumping money into the economy, it would make big losses when it sucked that money out.
A new paper from David Greenlaw, James D. Hamilton, Peter Hooper and Frederic Mishkin attempts to model what the next few years will look like for the Fed’s finances. They found that the Fed will be taking losses on its portfolio that peak at $35 billion in 2018, reducing the income that the Fed sends to the Treasury to zero in 2017 and 2018, after which it returns to normal levels.
“Continued expansion of the Fed’s balance sheet significantly raises the chances that the Fed will, for an extended period, cease to make positive remittances to the Treasury, especially if the Fed elects to sell some of its assets to speed up the runoff of excess reserves,” said the Greenlaw paper, presented Friday at the University of Chicago-Booth School of Business U.S. Monetary Policy Forum.
The great risk is that the political blowback from those losses would endanger the Fed’s independence. Could Congress, having grown accustomed to a gusher of money flowing forth from the Fed, grow angry with the feckless central bankers (Fed chief Ben Bernanke will likely be in the land of seven-figure book contracts and six-figure speaking gigs by that point, but expect his successor to get pilloried by Congressional overseers). In a worst case, lawmakers could become furious enough to try to limit the Fed’s ability to tighten the money supply, and thus its ability to prevent inflation from getting out of control.
At Friday's conference, St. Louis Fed President James Bullard added another wrinkle: That at a time when the Fed is no longer sending checks to the Treasury, it may also be paying banks tens of billions of dollars a year as “interest on excess reserves,” another tool the central bank intends to use to tighten the money supply when the time comes. That has appearance problem written all over it.
It’s clear that Fed leaders are starting to fret about the future. A paper by Seth B. Carpenter and four colleagues on the Board of Governors last month laid out the Fed staff’s best guess of what the numbers will look like; new minutes out this week show that the topic was discussed at the last meeting of the Federal Open Market Committee. Expect Bernanke to be asked about balance sheet at next week’s semiannual hearings on monetary policy. (Fed officials seem eager to have this conversation now, while they're making huge profits, perhaps so that lawmakers aren't surprised in a few years when the trend reverses).
The most widespread view within the Fed: Yeah, we may have a few years with no payments to Treasury. But over the full length of the economic cycle, taxpayers are still making money off of the Fed’s quantitative easing policies. And while we're tightening the money supply, the world's economy is getting better. In many ways, this would be a good problem to have -- and a sign our policies had worked.
Finally, and most important, the Fed is independent for a reason, and if a future Fed chairman faces pressure not to tighten policy, it is his or her job to ignore it.