Hummel on Fed's Billion-Dollar Losses
By David Henderson
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.]