Last month, Arnold Kling drew my attention to his deep pessimism and, I think, the rationale that the Fed could go bankrupt. But I don’t follow the Fed balance sheet the way my friend Jeff Hummel, an outstanding financial economist, does. So I asked her what she was thinking.
Jeff gave me a detailed answer, which I posted below. I have made several edits and he has approved them.
As I wrote earlier, I don’t believe Arnold Kling’s scenario is as scary and impending as he thinks. In the beginning, Kling claims to be much stronger than the article that Neil Irwin quoted. Irwin’s only concern is that rising mortgage rates will cause the Fed to unload the mortgage-backed securities (MBS) by lowering their market value. Kling goes further and claims that the Fed is facing bankruptcy even if it is stuck in those assets. I think the latter claim is weaker, not that the Fed isn’t having some problems. But Irwin’s argument is more credible.
It is true that the Fed’s overall balance sheet currently has significant maturity discrepancies, with short-term borrowings (bank reserves, currency, treasury deposits and reverse repos) and long-term lending (both Treasury and MBS). But identifying an organization’s balance sheet for the market, as Kling suggests, is not the best way to assess an organization’s well-being if it wants to retain all its assets until maturity. Until Fed assets are sold, Fed assets will continue to deliver their fixed returns (or inflation-adjusted returns of less than 7 percent of long-term treasuries). In that case, the Fed does not have to worry about changing the market price unless there is a direct default on its assets.
Even by default, the Fed does not hold any mortgages directly. Instead it can only hold MBS which is confirmed by one of the three federal government sponsored enterprises. So it’s not clear that the Fed itself will take a hit by default. Moreover, there does not seem to be a major concern about mortgage defaulters like the 2007-2008 financial crisis. The main concern is that mortgage interest rates are rising due to inflation or the Fed’s dumping of MBS in the market, leading to a fall in the value of the Fed’s MBS portfolio.
If the Fed doesn’t sell any MBS, Kling argues, inflation will still cause interest rates to rise on the Fed’s liability. To address this issue, we need to take a closer look at the Fed’s current balance sheet. As of May 11, 2021, its total liabilities were $ 8.94 trillion. Its total assets and capital must be equal. Of its assets, S 2.71 trillion was MBS (30.3 percent) and $ 5.77 trillion was Treasury securities and a small amount of federal agency debt (64.5 percent). The Fed has only 11 11 billion worth of asset gold certificates, valued at $ 42.2 per ounce. Other assets include minimum amount of treasury coins, SDR, foreign assets, special loan facility, bank premises (Fed building and other physical assets) etc.
Fed liabilities include $ 2.22 trillion in Federal Reserve notes (24.8 percent of its total balance sheet), bank deposits of $ 3.30 trillion (36.9 percent), and Fed loans in the form of $ 0.92 trillion (10.3 percent) treasury deposits. Reverse repo of $ 2.17 trillion (24.3 percent). The rest on that side of the balance sheet is the other small liability or Fed’s capital account ($ 42 billion). However, the only significant liabilities on which the Fed pays interest are bank deposits and reverse repo.
Thus, more than one-third of the Fed’s liabilities are essentially interest-free loans through Federal Reserve notes and Treasury deposits. And only in reverse repo interest rates are partially market driven, where interest rates on bank deposits (reserves) are set entirely at the Fed’s discretion. Furthermore, Kling’s suggestion towards the end of his post that the Fed may have to “persuade banks to keep reserves by raising interest rates on reserves” is completely wrong. A single bank can basically get rid of its Fed deposits in three ways. First, it can sell reserves to other banks, which has no effect on their total arrears. Second, banks can allow the Fed to convert Fed deposits into currency, which would actually reduce the amount of interest the Fed has to pay. Usually banks do the second to meet the currency demand of their customers. Third, a bank can convert reserves into reverse repo loans to the Fed, but since the Fed sets the reverse repo rate below the reserve interest rate, it also reduces the Fed’s interest costs. In short, no matter how high the market interest rate, the Fed will not have to raise interest rates on reserves so that banks can hold on.
Indeed, despite the omission of the formal reserve requirement in 2020, banks are still subject to the underlying reserve requirement through the back door. In 2015 the Fed imposed the Liquidity Coverage Ratio (LCR) of the Basel Accord, which I wrote here and here. LCRs do not only force banks to hold more high-quality liquid assets, such as reserves, they may choose otherwise. However, other types of capital requirements, including stress tests, are similar, non-universal and sometimes This Liquidity Requirements, detailed by Bill Nelson and Francisco Kovas.
Of course, reserve interest rates can affect how much money banks make through money multipliers. But since the Fed can always change the amount of reserves, we now have a complex mix of policy options that the Fed can play. The Fed raised interest rates from 0.04 percent to 0.09 percent in early May and 0.03 to 0.08 percent in the reverse repo. So for the sake of argument, consider an extreme stylized case where both rates increase by a further 1.0 percentage points and everything else remains the same. The Fed’s annual revenue would then fall by 54.7 billion ([3.30 trillion + 2.17 trillion] x .01]). Initially, all that needs to be done is to reduce the amount of money that the Fed regularly pays to the Treasury. Although before the financial crisis, the Fed was sending an average of only $ 30 billion a year in additional revenue to the Treasury, as the Fed’s balance sheet has grown exponentially since the financial crisis, that amount has more than doubled on average. In 2021, $ 109 billion remittances were sent. Before further expansion of the Covid Fed’s balance sheet, remittances temporarily dropped to $ 56 billion in 2019, but this was their lowest since at least 2010.
So the Fed seems to have ample room to spread income between assets and liabilities, which could fall without serious problems for a few years, after which market conditions may change. Even if continued inflation at current highs (both you and I suspect) eventually leads to Fed policy that reduces remittances to zero and losses begin to hit Fed Capital, the Treasury could raise its interest-free deposits in the Fed before then. , Easily and quickly replace the interest-bearing repo of the Fed. Treasury deposits were used by the Fed as a major source of funding during the financial crisis, and reached a peak of 1.7 trillion during the Covid. Soon after, reverse repo started replacing treasury deposits, which dropped to $ 550 billion in September 2021, but they are rising again.
Or, with congressional approval, various accounting strategies could maintain the Fed’s nominal sovereignty. In 2015, for example, Congress passed a transportation law that puts a cap on the Fed’s surplus capital, the amount of capital that exceeds the amount paid by member banks. So that year, the Fed had to shift মূল 19.3 billion from its capital account, in addition to its regular $ 97.7 billion remittances to the Treasury. Again, in 2018, the Fed surpassed নিয়মিত 3.2 billion from its capital account on top of its regular remittances. There is no reason why Congress should not have provided substitution for the Fed’s capital account instead, although doing so would probably attract more public attention. Or, if pushed, the Treasury gold price could be revalued from $ 42.2 per ounce to its current market price of $ 1,800 per ounce. At most, it could raise মূল 450 billion in its capital account. Not that I think it would probably be necessary if the Fed stayed with its MBS.
I acknowledge that if the Fed seeks to reduce MBS sales in the secondary market, rising mortgage interest rates create more serious problems. Any net loss in Fed’s earnings assets is inevitably going to reduce Fed’s remittances to the Treasury, whatever else happens, just as past net purchases have increased remittances. True, a large part of the current rise in mortgage rates is from the unusually low rates of 2021. The annual average rate for a 30-year permanent mortgage has now risen to 5.25 percent. The full-year average for 2021 was just 2.96, while in 2018 that average was 4.55 percent. And for most of the year between 2019 and 2021, it was above 4.00 percent. I think the Fed, based on past performance, could stop selling MBS, but only if the mortgage rate is not too high.
Before the Fed began buying MBS, the 30-year fixed mortgage rate was typically around 6.00 percent and, if we go back to the 1990s, even higher. So MBS’s Fed Holdings could lower the mortgage rate by as much as two percentage points. If so, the price at which the Fed sells MBS could be quite low, eventually wiping out Fed remittances to the Treasury. And in this case, the GSE guarantee will make no difference. The options available, however, are the same as the ones I mentioned above while hanging on to the Fed’s MBS. But if Irwin is right, his prediction is quite ironic: the very high inflation that the Fed itself has created reduces its ability to reduce the size of its inflated balance sheet. Still, the Fed could easily downgrade its MBS portfolio, as Irwin noted, by “shrinking its holdings” as it matures and not rolling over the portfolio with new purchases. Unfortunately, most of its MBS portfolio, amounting to 2.6 trillion, has a maturity of more than 10 years, unless the underlying mortgages are repaid in advance.