How
Fed Buying of Long Term Assets Could Lead to Wild Inflationary/Deflationary
Swings and Perhaps Fed Bankruptcy
by
Robert Wenzel
Economic
Policy Journal
Recently
by Robert Wenzel: Read
FDR's Executive Order Banning Gold
Glenn
D. Rudebusch, of the San Francisco Federal Reserve, has done a great
job of explaining why the Fed is
in danger of eventually going cash flow negative on its portfolio.
He writes:
...the Federal
Reserve has purchased large amounts of longer-term securities
in recent years. The Fed's resulting securities portfolio has
generated substantial income but may incur financial losses when
market interest rates rise.
He goes on
to explain the size of the problem:
....the
Fed’s recent securities purchases have caused its balance
sheet to grow enormously. Just before the financial crisis, the
Fed’s largest financial asset was about $0.8 trillion in
Treasury securities, and its chief liability was a similar amount
of currency outstanding in the form of Federal Reserve notes.
The Fed now holds about $2.4 trillion in Treasury and federal
agency securities. These assets are roughly balanced by a similar
amount of currency and bank reserves, which can be thought of
as the electronic equivalent of currency...Furthermore, besides
producing a larger balance sheet, the Fed’s purchases have
shifted the composition of the Fed’s securities portfolio
toward longer-maturity securities. Indeed, the duration of the
Fed’s portfolio – which is roughly a measure of average
maturity – rose from between two and three years before the
financial crisis to between four and five years now. The longer
duration of the Fed’s portfolio implies that its market value
is more sensitive to changes in interest rates. The combination
of a larger securities portfolio with a longer duration implies
that the Fed is taking on more interest rate risk than usual.
Here are the
mechanics of the problem:
In understanding
the Fed’s interest rate risk, it is useful to separate the
effects of rising short-term interest rates from the effects of
rising long-term interest rates. In general, when short-term interest
rates rise, the manager of a portfolio financed by short-term
liabilities faces increasing interest expenses. Similarly, when
short-term interest rates rise, the Fed will pay a higher interest
rate on bank reserves, which increases the funding cost of its
securities portfolio. In contrast, the Fed’s interest income
that is generated from its holdings of fixed-coupon longer-maturity
securities will be essentially unaffected. Thus, rising short-term
interest rates will squeeze the Fed’s net interest income...In
2010, the Fed earned $82.9 billion in interest income, which is
equal to an average coupon yield of around 4% applied to a $2
trillion portfolio of longer-term securities. The interest expense
for funding these assets last year was only $3.1 billion, which
is equal to the Fed’s reserves rate of 0.25% applied to more
than $1 trillion in bank reserves. If short-term interest rates
were to rise, the Fed’s net interest income would fall as
interest expenses rose and its fixed-income earnings changed little.
Importantly though, currency, which now represents about 40% of
Fed liabilities, has a zero funding cost. So, short-term interest
rates would have to rise rapidly to quite high levels – in
the neighborhood of 7% – for the Fed’s interest expenses
to surpass its interest income. Such an outcome appears very unlikely.
Read
the rest of the article
April
12, 2011
©2011
Economic Policy Journal
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