David R. Henderson  

Hummel on Fed's Billion-Dollar Losses

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Henderson on John Stossel Show... Tim Kane and Means-Testing...

The last temptation is the greatest treason:
To do the right deed for the wrong reason.

--T.S. Eliot, "Murder in the Cathedral"

I was reminded of this quote when reading an e-mail Jeff Hummel sent to a few of his friends. Jeff pointed out that he's "always happy when the Fed[eral Reserve] gets negative publicity."--the right deed. But, he noted, "much of its negative publicity focuses on minor issues."--the wrong reason.

He was responding to another friend's mention of this Bloomberg story. Jeff wrote, "I have to agree with the quoted Congressman who suggests that the prospect of potential Fed losses tends to be 'simply an optics problem about which we should not be concerned.'" Jeff's reasons follow:

1. The article reports on stress tests that mark to market the Fed's balance sheet under different scenarios. But the losses from marking to market are not particularly relevant for debt securities held to maturity, whether those held by a private bank or a central bank. And the Fed usually holds all its long bonds, both mortgage-backed or Treasuries, to maturity, as the article points out. In that case, the only potential source of loss is outright default on some of the securities, and so far that has not been a problem even with the Fed's mortgage-backed securities, which are all already guaranteed by the Treasury anyway.

2. Any increase in inflation would reduce the real value of the Fed's portfolio. But such higher inflation could result from only one of two causes: (a) the Fed increasing the monetary base, or (b) the banks expanding their deposits on top of that base. If (a), any real losses on the part of the Fed would be more than dwarfed by its gains from printing new money.

3. If (b), the inflation would not be sustained. Instead, the effect would be a one-shot increase in the price level. And the Fed has various tools for preventing or offsetting (b). (i) It could sell securities, and if it had to sell some long-term securities before maturity, it could suffer some capital losses. But it still holds at least half a trillion worth of securities that either have short maturities or are inflation-protected, that it can sell first. (ii) It could increase the interest rate it pays on reserves, which would restrain bank lending. This would reduce Fed earnings, but remember that one trillion of its "liabilities" are Federal Reserve notes on which it never pays interest. (iii) Or what amounts to the same thing, the Fed could use what Bernanke refers to as "draining tools," by which it borrows money and pulls it out of circulation. This of course creates some interest-rate risk.

4. Using any of these three tools would likely reduce somewhat the amount of money the Fed remits to the Treasury, and the amount might even fall to zero. But so what? The tripling of these remittances as a result of the financial crisis from around $30 to $90 billion annually still constitutes at most only 3 percent of total federal revenue. Why do this remittances all of a sudden become critical after having been overlooked for so long?

5. The problem that Mishkin and Bernanke talk about, "fiscal dominance," is when Treasury pressure induces the Fed to monetize the growing national debt. But this is just increasing the monetary base, as in (a) above, which as mentioned, would increase Fed earnings.

The bottom line: the Fed is a giant legalized counterfeiter that cannot go bankrupt. Unless it pursues a drastically inflationary policy to cover government expenditures (which is always possible but in my opinion not likely), the seigniorage it provides to the Treasury will remain an unimportant source of government receipts. The real problem is its current attempt to manipulate the structure of interest rates in order to centrally plan credit allocation. [Emphasis added.]


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CATEGORIES: Monetary Policy , Money



COMMENTS (4 to date)
Joe Teicher writes:

I have a question about the fed's earnings. Right now they have about $3T in treasuries and other bonds. The $90 billion/year they are returning to treasury seems to mainly be coupons. What happens when one of the bonds they are holding matures? Do they count the whole principal payment as revenue or do they not count it as anything and just buy another bond?

If they don't count the principal payments on maturing bonds as revenue, then that really gives a distorted picture of their impact. For instance, if they bought all the treasuries, they would only be "earning" a few hundred billion annually because that's all the treasury pays in interest. Jeff Hummel would say that they are contributing less than 10% to federal revenue and that's not very important. And yet, they would have effectively brought the national debt to 0.

If they do count the principal payment at maturity as revenue, then we should expect them to start reporting much more than $90 billion/year as those $3T of bonds they own start to mature in greater numbers. I think the duration of their portfolio is around 10 years so they should be "making" around $300+ billion per year.

Jeff Hummel writes:

Joe: But remember. The Fed will usually roll over the proceeds from maturing bonds into new securities or loans--unless it wants to contract the monetary base. If it is contracting the base, any income is offset by a decline in Fed liabilities, either Federal Reserve notes or bank deposits. This is just like any private financial intermediary that may decide to retire its loans in order to pay off its debts. The big difference is that Fed "liabilities" are not genuine debts originated through a market process but instead can be increased or decreased at Fed discretion. So you are right, the Fed could theoretically create base money not to buy financial assets but to cover its operating expenses or pay remittances to the Treasury. But it can always do that irrespective of whether any bonds it is holding are maturing or not.

Steve writes:

I followed this piece and excerpt right up until the last paragraph - which really appears to be the principle point Jeff is making... Now off to read the linked piece (real problem) but I reserve the right to come-back here and ask some questions. A little more editorial commentary might have helped me finish understanding the thought line - but I am glad you put up this piece. Personally I think the Fed is holding the economy together as best they can with duct-tape because Congress is having such difficulty functioning.

Steve writes:

OK. Back from reading the piece on Bernanke's efforts to allocate credit.

My question is this: in the absence of leadership elsewhere (literally *anywhere* these days), what is Bernanke's alternative? In my mind he has none. He can keep credit available. He can force rates down.

He can't make people want to borrow and or spend and he can't make businesses invest - and these are the activities needed for the economy to recover. What power does the Fed have to make these activities happen (and we certainly would agree that we don't want the Fed to have this kind of power)?

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