Diary of a Financier

Future Monetary Policy, As Governed by the Fed’s Interest Rate Risk

In Economics on Tue 12 Apr 2011 at 23:57
  • With a balance sheet asset-liability mismatch, the Fed is structured like a giant SIV.
  • To honor withdrawals from its excess bank reserve deposits, the Fed can sell assets (shrinking balance sheet) or issue currency (maintaining balance sheet).
  • Since mass asset sales threaten price stability and large-scale currency issuance risks inflation, the Fed’s priority must be to avoid a “central bank run” by preemptively raising the excess bank reserve rate, which would keep $1T worth of deposit financing on the Fed balance sheet.
  • If still presented with deposit withdrawals, the Fed would sell assets first, without heed to its own capital gains/losses. There is, however, a breaking-point at which the Fed’s firesale can threaten its mandate of price-stability, and at this point, the Fed would have to resort to currency issuance.

Yesterday, the Federal Reserve Bank of San Francisco (FRBSF) released a new economic letter, which “provides a financial assessment of the Fed’s interest rate risk and places that risk in the context of the Fed’s macroeconomic goals for monetary policy.”  While the FRBSF tends to cheerlead a bit too hard, it has unveiled some great white papers in the past.  This most recent edition is no exception, and I wanted to undress it with my reaction.  This reads like a primer on the Fed’s potential qualms and available options in managing its balance sheet over the coming years.

First, some interesting updates on the Fed’s income statement:

After accounting for other income and operating expenses, the Fed’s 2010 net income was $81.7 billion. From this amount, the Fed added to its capital reserves and paid dividends to its member banks. It then remitted the remainder—$79.3 billion—to the Treasury. While the Fed has a substantial net income cushion, it must still consider the risk of capital losses on its securities portfolio when long-term interest rates rise…

…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…

Fed Income Statement FY2010

…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.

Like the SIV folly of financing long-term assets with short-term liabilities, the Fed’s balance sheet can succumb to the same asset-liability mismatches.

Composition of Fed Balance Sheet- Assets & Liabilities

In claiming that ‘the Fed’s interest rate risk is stable barring a rapid rise in short term rates to 7%,’ the FRBSF seems to forgo any mention of practical pitfalls.  Conceptually, if rates were to rise suddenly–even a quick 50 bp uptick–a “run on the [central] bank” could ensue as those $1T in bank reserves earning 25bps would seek other means. Here’s where this gets interesting…

Like a SIV, the Fed’s first option to meet deposit withdrawals is liquidating assets to raise cash. The cash proceeds honor the redemption request directly. The flailing SIVs of 2008-09 were force-liquidating in a panicked market to meet redemption requests. With a quick spike in interest rates, the Fed–having to rain waterfalls of assets onto the bid–could create the same panicked marketplace.  Such matching of asset sales to meet deposit withdrawals would reduce the size of the Fed’s balance sheet.

Unlike a SIV, the Fed’s second option is to issue currency to cover the excess reserve withdrawals, which would maintain the same gross assets & liabilities and therefore the same sized Fed balance sheet. Currency is just a zero-interest liability of the Fed, but willy-nilly issuance can stoke inflation.

In practice, we’d most likely see the Fed utilize a combination of the two approaches. If $500B in bank reserves on deposit with the Fed are withdrawn, the Fed could always attempt an orderly liquidation of a multi-billion dollar block of Treasuries/MBS over time, particularly since they’re sitting on substantial unrealized gains ($71B at the end of 2010, for which they’d probably even be willing to compromise on bid price to a buyer).  In the interim, they can cover deposit withdrawals with currency issuance.

Finally, the all important denouement: the FRBSF seems to make the critical assumption that [long-term] Fed assets will be held-to-maturity, not sold. If I held that at its word, it would leave currency issuance as the Fed’s only tool to honor excess reserve withdrawals.  Again, if substantial enough, such issuance would be inflationary.  In practice, however, the Fed will inevitably sell a portion of its assets, particularly as MBS prepayments continue to wane.

If all you have is a hammer, everything looks like a nail.  To avoid having to pull out its hammer (i.e. currency issuance) and risk inflation, the Fed can only try to prevent withdrawals (i.e. preemptively raising the reserve rate ahead of market rates).  Hypothetically, infusing currency into an economy where rates are already rising all on their own–undeniably due to inflation expectations–would be too rogue.  Therefore, while I find that FRBSF “hold-to-maturity” assumption risky, I also find it to be the most desirous outcome for Ben Bernanke’s Fed. This sequence suggests that the Fed will raise the reserve rate preemptively as its next policy motion–perhaps coupled with the expiration of QE2 in June. Such a move stems-off inflation expectations by keeping banks’ cash on deposit with the Fed, instead of levered-up and sloshing around in the real economy. For any bank that still opts to withdraw some cash (hypothetically for lending opportunities), the Fed has a low-capacity tool called “reverse repo,” which can keep a few such dissenting banks in check by essentially offsetting their withdrawals with cash calls.

To the extent that inflation expectations set-in so acutely and so quickly as to drive up interest rates quicker than the Fed can hike the reserve rate, the Fed would still not want to issue currency, so as to not exacerbate the problem. It would rather reduce its balance sheet via asset sales to honor any onslaught of redemptions. Some of the Fed’s non-Treasury assets were purchase at 60 cents-on-the-dollar. These trade north of 95 cents in today’s functioning markets, although the Fed’s officially reported carrying value is its purchase price. (“…the Fed values its securities at acquisition cost and registers capital gains and losses only when securities are sold. Such historical-cost accounting is considered appropriate for a central bank that is motivated by macroeconomic policy objectives rather than financial profit and is consistent with the buy-and-hold securities strategy the Fed has traditionally followed.”)

The Fed would sell without heed to its gains.  It would sell at a capital loss if necessary.  But there comes a breaking point, as we must remember the Fed’s “statutory mandate… to promote maximum employment and price stability… Financial considerations–even potentially large capital losses–are secondary.” Mr. Bernanke argued in a 2000 paper, “to allow consideration of possible capital losses to block needed policy actions is misguided.” I would generally agree, unless the Fed were forced to liquidate assets in a firesale that drove prices back below 60 cents-on-the-dollar. Such a pricing whipsaw would fail the Fed’s price-stability mandate. Thus, there comes a point where currency issuance partners with asset-sales as part of the solution-mix.

Invest accordingly.

–Romeo

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  2. […] QE stimulus is on deposit with the Fed, playing the carry trade in excess reserves. The Fed almost needs those excess reserves to remain there, not in the real economy, to avert material inflation. Plus, […]

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