There is an increasing focus on the Fed’s recent losses on its bond portfolio, which has declined in value as interest rates have risen:
The US Treasury will see a “stunning swing,” going from receiving about $100 billion last year from the Fed to a potential annual loss rate of $80 billion by year-end, according to Amherst Pierpont Securities LLC.
Here are five perspectives on the issue:
1. The Fed is part of the federal government’s consolidated balance sheet. Thus, when Treasury bond prices decline, the loss to the Fed is exactly offset by the gain to the Treasury. It’s not an issue.
2. While point #1 is true, if the Fed had not bought those bonds, then the Treasury would have gained when T-bond prices plunged. Thus the Fed’s decision to buy lots of T-bonds has created a loss relative to the counterfactual world where they did not accumulate a large bond portfolio.
3. While points #2 is true, the ultimate cause of the sharp bond price decline is the recent surge in inflation. Inflation helps borrowers (such as the US Treasury). That inflation surge would not have occurred if the Fed had not purchased lots of bonds in its QE programs.
4. Point #3 is partly true, but the Fed’s large bond portfolio also reflects its decision in 2008 to begin paying interest on bank reserves (IOR). Had the Fed not made that decision, it could have operated with a smaller balance sheet, and thus would have occurred smaller losses during the recent upsurge in interest rates.
5. Point #4 is true, but it’s also true that the Fed’s large bond purchases allowed it to make extraordinarily large profits during the low interest rate era of 2009-2021. It remains to be seen whether this policy is a net negative or positive in the long run.
On balance, I oppose IOR for a variety of reasons. But I don’t believe there is any clear and straightforward way of thinking about the Fed’s recent losses. I tend to view policy issues from the perspective of “counterfactuals”. If policy X produces the best result, then a less ideal result that we actually get is the true opportunity cost of not doing policy X. I tend not to focus very much on Fed accounting profits and losses, because the macroeconomic effects of Fed policies is many orders of magnitude more important. If the Fed stops paying IOR and focuses on the policy that results in low and stable NGDP growth, then the profits and losses will become a trivial issue.
READER COMMENTS
vince
Nov 8 2022 at 12:27am
The Fed would have no losses if it weren’t paying IOR and weren’t investing in long-term assets. One could argue the Fed shouldn’t be engaging in either one of those activities. Those arguments are that IOR replaces market-driven interest rates (based on supply and demand), and that long-term asset risks should be left to markets.
Scott Sumner
Nov 8 2022 at 12:38am
“The Fed would have no losses if it weren’t paying IOR and weren’t investing in long-term assets.”
In that case, they’d probably have to raise the inflation target to at least 3%. Otherwise, how would they find enough assets to buy to hit the target?
Speed
Nov 8 2022 at 6:58am
Is this a case of ignoring that “all bonds go to par at maturity”?
If I buy a bond at par (a new issue for example) its market price will vary with interest rates but at maturity it will be redeemed by the issuer at par — assuming that the issuer doesn’t go belly-up (a technical term).
vince
Nov 8 2022 at 11:40am
“Is this a case of ignoring that “all bonds go to par at maturity”?”
If you’re referring to losses, no. It’s maturity mismatch. The loss is from low long-term interest income being offset with high short-term interest expense. If the Fed sold those long-term bonds, the loss is even higher.
Spencer
Nov 8 2022 at 7:40am
The IOR increases the supply of loan funds while decreasing the demand for loan funds (taking debt off the market). It is essentially an asset swap (increasing outside money). But reserve velocity is not tracked. And Greenspan eliminated the transactions velocity of money reporting.
The payment of interest on IBDDs artificially suppresses nominal and real rates of interest, the siphoning of funds dissipated in financial investment (the transfer of title to goods, properties, or claims thereto), as opposed to real investment. I.e., it stokes asset prices.
Thus, the IOR increases income inequality. Paying Interest on Reserve Balances: It’s More Significant Than You Think is an ipsedixitism.
FRBSF: “Paying interest on excess balances should help to establish a lower bound on the federal funds rate.” But interest is the price of loan funds, not the price of money. The price of money is the reciprocal of the price level.
It is axiomatic, the money stock can never be properly managed by any attempt to control the cost of credit.
The only tool, credit control device, at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be properly controlled is legal reserves. Powell eliminated legal reserves in March 2020. And Powell also eliminated deposit classifications.
Monetarism has never been tried.
Spencer
Nov 8 2022 at 8:51am
re: “Otherwise, how would they find enough assets to buy to hit the target?”
You’ve got to be kidding?
Capt. J Parker
Nov 8 2022 at 11:58am
The way to think about Fed losses right now is: Do they make it easier or harder for the Fed to have a contractionary monetary policy? If the Treasury needs to make transfers to the Fed so Fed can meet rising IOR payments, Treasury will need to issue more debt. Raising taxes or cutting spending elsewhere is not likely. This means that we have (even greater) expansionary fiscal policy competing with contractionary monetary policy.
It’s time for the Fed to start talking about increasing reserve requirements and tapering IOR.
If I were king I’d have forced purchases of Fed held treasury debt by every financial institution that benefited from earlier purchases by the Fed of securities those institutions once held.
The one thing you don’t want to have is House and Senate “investigations” into why, while average Americans are suffering with record inflation, do we need Treasury to pay the Fed so the Fed can pay the banks.
Scott Sumner
Nov 8 2022 at 1:32pm
“It’s time for the Fed to start talking about increasing reserve requirements”
A few months back I did a post criticizing that idea.
Capt. J Parker
Nov 8 2022 at 2:42pm
This post I presume? We both agree on wanting to see an end to IOR somewhere down the line. What is the path to get there?
Scott Sumner
Nov 8 2022 at 6:04pm
This one:
https://www.econlib.org/time-to-pay-the-piper/
vince
Nov 8 2022 at 6:31pm
Thanks for the link to the article that says: “Central banks have essentially been running a giant hedge fund. Why should commercial banks have to pick up the tab on those occasions when the bets of the central bank turn sour?”
My question is, Why should central banks run a giant hedge fund?
Capt. J Parker
Nov 9 2022 at 11:04am
Thanks very much for the link.
If all the excess reserves were due to the Fed buying Treasury debt then IOR is looks a lot like it is just interest on Treasury debt EXCEPT now, as you point out, all the Treasury debt held by the Fed is now forced to pay (recently higher) short term rates. So, in this case, I totally somewhat agree that it, in fairness, Treasury should pay the interest on it’s own debt rather than the banking system paying the interest on Treasury debt through rules that act like an implicit tax on bank assets.
But, a third of the Fed’s balance sheet is still non-Treasury debt purchased from the banking system beginning in 2008 and maintained at a high level. So, if it is now time to pay the piper for the banking system bailout, in fairness, Treasury should not have to foot the bill for that.
IOR needs to wind down. In the process of that wind down while the Fed is also truing to bring down inflation, banks may need to be incentivized to hold excess reserves. The incentive can be through a bonus or a penalty. Is there an economic efficiency reason rather than a fairness reason favoring one as opposed to the other?
Scott Sumner
Nov 9 2022 at 12:51pm
Vince, I’d prefer a smaller central bank balance sheet.
Capt. Parker, Sorry, I don’t follow your argument.
Capt. J Parker
Nov 9 2022 at 2:03pm
Dr. Sumner
Thanks for the responses. I’ll endeavor to be clearer if and when IOR and Fed losses come up again.
Spencer
Nov 8 2022 at 1:13pm
re: increasing reserve requirements and tapering IOR
Powell has no clue. Powell doesn’t understand that banks are never intermediaries. Bank lending is endogenous, not exogenous.
Since Powell eliminated deposit classifications, reserve requirements should be applied to all deposit liabilities, regardless of the size of the bank. Then you could eliminate the perverted IOR and sterilize LSAPs, the monetization of debt.
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