The prospect of losses on the Federal Reserve’s holdings of securities is a real issue for U.S. taxpayers, a former top central bank staffer wrote in a research note Wednesday.
Bill Nelson, who now works as chief economist for the Bank Policy Institute industry group, was responding to a report released by the New York Fed on Tuesday. In that report, the bank said the Fed likely suffered paper losses on bonds it owned this year and that those paper losses could be substantial over time depending on how monetary policy plays out.
To the Fed, losses on the Treasurys and mortgage securities it owns aren’t meanfingul to its broader mission of using its policy tools. The central bank holds securities to maturity, so lost value isn’t an issue in its view.
The paper losses are a result of the rapid shift in monetary policy to tackle high inflation, which has caused big sell offs for all manner of bonds. Securities purchased by the Fed are now worth less than when the central bank bought them during its stimulus efforts. Depending on how short-term rates rise, these paper losses could grow over time, the New York Fed noted in its report.
The idea that these paper losses are water under the bridge is simply wrong, according to Mr. Nelson. And that’s because of the mechanics of monetary policy.
Under the Fed’s current monetary policy system, lifting interest rates causes the central bank to pay more on the cash it takes in from banks, dealers, money funds and others. The Fed funds itself with income earned on bonds it owns and services it provides the financial system.
The Fed hands its profits to the Treasury every year—it gave back some $107 billion last year. But as rates rise, the central bank’s bonds lose value, its expenses increase and its profits shrink, and at some point the Fed may not be able to hand any cash to the government at all, something the New York Fed report flagged as a real possibility.
Mr. Nelson said the interplay between the Fed’s interest expenses and the value of its bonds isn’t cost free.
“When a Treasury security owned by the Fed declines in value, that decline equals the expected rise in the Fed’s funding cost,” Mr. Nelson wrote. “Even though the future interest income from the security is unchanged, the interest expense required to finance the security has risen.”
Put another way, “the reduction in the value of the security is also exactly equal to the reduction in the current value of those remittances,” Mr. Nelson wrote.
Fed observers generally see the issue around how much money the central bank sends to the Treasury as a political one, because it is able to operate and work toward its monetary policy goals even when it books losses through accounting measures.
But money the Fed hands the Treasury is viewed as a funding source for reducing the U.S. government’s deficit, even though some of that money is derived from interest on Treasurys, which means the Fed is merely handing back money paid to it by the Treasury to begin with. Some experts worry that a loss-making Fed could face heat from lawmakers, although there is little clarity what Congress might do in such a situation.
“When the Fed buys longer-term securities, purchases that are funded with overnight liabilities, it is taking on real financial risk, just as would be true if a hedge fund were to do the same thing,” Mr. Nelson wrote. “That risk is a cost that the Fed needs to consider when making its decision, and a cost that Congress and the public need to consider when holding the Fed accountable.”
Write to Michael S. Derby at [email protected]
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