Fed Risks Losses From Bonds

Seth Carpenter, W&M BA'92, is a member of the Jefferson Board of Advisors.

WSJ
The Federal Reserve could be charting a course that leaves the highly profitable central bank with no extra income to hand over to the U.S. Treasury for several years.

That is the conclusion of five Fed staff economists who examined how the central bank's bond-buying programs will affect its profitability over the long run.

Right now the Fed is earning large returns on its bond portfolio and sending most of its profits to the Treasury. Several years from now, when the economy is stronger, the Fed is expected to sell bonds and raise short-term interest rates to tighten credit and restrain inflation. The group found the Fed might have to sell bonds at a loss and incur higher expenses on interest it pays to banks on the reserves they hold at the Fed.

That, in turn, could become a political headache for the Fed, and might even weigh on some officials today as they decide whether to continue these programs, which are aimed at driving down borrowing costs and spurring economic growth and hiring.

The issue could come up at the Fed's two-day policy meeting that concludes today. The central bank is widely expected to vote Wednesday to continue its bond-buying programs.

The Federal Reserve doesn't make monetary-policy decisions based on its projected profits or losses and most officials are confident the Fed could continue to operate without problems even with large losses.

Still, minutes of the Fed's December meeting showed officials are considering the matter as they evaluate the bond-buying programs, which are adding $85 billion a month in mortgage and Treasury securities to their $3 trillion portfolio.

Under law, the Fed is required to use its income to cover operating expenses and send much of the rest to the Treasury's general fund. Of the $91 billion the Fed earned last year, it sent nearly $89 billion to the Treasury, a record amount.

If the Fed were to record a loss, it could print its own money to cover its expenses—at no cost to the Treasury. The Fed would record a loss as a deferred asset, which would represent how much money the Fed would need to make up before it started sending profits to the Treasury again.

The Fed economists—led by Seth Carpenter, senior associate director in its monetary affairs division—examined how much money the Fed would earn or lose as the bond-buying program develops and as monetary policy changes. They project continued profits in the short run, but see losses several years out if the Fed has to sell the securities at a loss or raise interest rates to fight inflation.

In one scenario, they examined what would happen if the Fed increases its portfolio to $3.75 trillion in the months ahead, but then sells securities and gradually raises short-term interest rates from near zero today to 3.8% starting in late 2014.

In that case, the Fed could face a stretch later this decade in which it accumulates $40 billion in losses and goes four years without making payments to the Treasury starting in 2017, the study found. A jump in short-term interest rates to 4.8% could lead to $125 billion in losses and six years without paying profits to the Treasury, starting in 2016.

The implications of such a scenario are complicated. The Fed would record the amount of the deferred assets—something it has never done before for more than a week or so at a time—and the bigger the losses, the longer it would defer Treasury payments.

Such deferrals, the authors said, "would not have any implications for the [Fed's] ability to conduct monetary policy." Still, some observers say the Fed could be in for political headaches if it has to go a while with no income to hand over to the Treasury.

Donald Kohn, the Fed's former vice chairman, said Fed chairman Ben Bernankeshould speak out to explain his thinking on this issue in detail "to minimize misunderstanding when losses occur and reduce the odds of a backlash that could end up impairing the Fed's independence" if Fed payments to the Treasury dry up.

"The fact that its contribution to federal revenues will swing from current inflated levels to zero—or close to it—will lead to a lot of second-guessing from congressional budgeters," said Louis Crandall, an economist with Wrightson ICAP LLC, a Wall Street research firm. "This could very well be messy."

The Fed economists argued that by helping to support the recovery, these bond-buying programs in the long run help taxpayers because they mean faster economic growth and more tax revenue. In the coming decade, their projections show the Fed remitting more than $200 billion to the Treasury even with a large balance sheet, making the program a net profit in the long run.

Write to Victoria McGrane at victoria.mcgrane@wsj.com and Jon Hilsenrath atjon.hilsenrath@wsj.com

A version of this article appeared January 30, 2013, on page A2 in the U.S. edition of The Wall Street Journal, with the headline: Fed Risks Losses From Bonds.