When the Federal Reserve vowed to do "whatever it takes’’ to fight the financial crisis, it did more than just reduce its benchmark overnight interest rate to nearly zero. It also became the world’s single biggest bond holder, essentially printing money to buy up more than $1 trillion in mortgage-backed securities and more than $700 billion in long-term Treasury bonds. That massive effort financed the bulk of new mortgages during the past two years, and it propped up the overall economy by pushing down long-term interest rates of all types.
But now, analysts say, the Fed faces the prospect of jaw-dropping losses on its gigantic new bond portfolio whenever it starts to nudge interest rates up to more normal levels. As interest rates rise, the market value of its portfolio will sink as investors slash the prices they are willing to pay for existing bonds in order to match the higher yields of new ones.
Though many of those losses will only be on paper, they could nonetheless reduce the Fed’s real annual earnings by tens of billions of dollars. That would aggravate the federal budget deficit, because the central bank hands over most of its profits to the Treasury. Experts say Fed officials have never before found themselves in this type of economic box.
Laurence H. Meyer and Antulio Bomfim, economists at Macroeconomic Advisers, estimated in a new report that the value of the Fed’s bond portfolio could drop by $100 billion for every increase of 1 percentage point in interest rates. The Fed won’t have to book any losses if it simply holds its bonds until they reach maturity. But Fed officials decided last month to gradually sell off their holdings some time after they start raising interest rates. Many analysts expect that process to begin sometime next year.
Even if the Fed keeps much of its portfolio for years, it will be caught in an interest rate squeeze. It will paying higher rates on reserves that banks keep on deposit at the Fed, but it will be earning the same low rates as before on its portfolio of fixed-rate bonds.
"Some of the issues the Fed may encounter in a rising rate environment are closer to those facing a hedge fund,’’ Meyer and Bomfim wrote in a research note last week. But in sharp contrast to a hedge fund, the Fed will be in the peculiar position of causing its own losses because its own policymakers will be the ones pushing up interest rates. That inherent conflict of interest has provoked worries among some investors that the Fed’s interest as a bondholder could clash with its core mission of steering the economy by setting interest rates.
The Fed’s looming interest rate squeeze is the mirror image of its soaring profits as a result of low interest rates. Last year, the Federal Reserve’s net income jumped to a new record of $53.4 billion, up from $35.5 billion in 2008.
Most of that income stemmed from the spread between the incredibly low interest rates it paid on reserves and the higher rates it earned on long-term holdings.
But the Fed’s interest rates on reserves was only about a quarter of a percent last year. If it raises overnight rates to 4 percent, which would still be lower than they were just before the crisis, Bomfim estimated that its interest cost would be about $40 billion higher – almost enough to wipe out its net income.
The Federal Reserve has never been in this kind of position before. In fighting previous recessions, the central bank simply lowered its benchmark federal funds rate – the rate banks charge each other for overnight loans – to increase the supply of cheap money. The federal funds rate is also the base for other interest rates, including the prime rate that banks charge their best, lowest risk customers.
But the financial meltdown was too severe for that. In late 2008, the Fed not only slashed overnight rates almost to zero, but began driving down mortgage rates by buying up long-term Treasury bonds and government-backed mortgage-backed securities. It also created a raft of emergency lending programs, trying to fill the void left when private capital markets imploded.
As a result of that "quantitative easing," the Federal Reserve’s balance sheet has ballooned from about $900 billion in September 2008 to more than $2 trillion today. And instead of holding mainly short-term Treasury bills, it now holds $1.3 trillion in mortgage debt and $700 billion in long-term Treasury notes and bonds.
The huge new portfolio has complicated the Fed’s strategy for getting policy back to normal as the recovery gains pace. To prevent a surge of inflation or another round of asset bubbles, Fed officials eventually have to both raise the overnight fed funds rate and to reduce their bloated portfolio. Fed Chairman Ben S. Bernanke has already laid out a broad "exit strategy."
At the Fed’s policy meeting on April 27 and 28, moreover, Fed officials agreed that they would gradually sell off the long-term portfolio.
According to minutes of the April meeting, policymakers "agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions." In a note that brought sighs of relief from many bond investors, the minutes also disclosed that "a majority of the participants" support postponing any sales until after the Fed has announced its first increase in overnight rates.
Fed officials, concerned that the economy remains very fragile and increasingly worried about the fallout from Europe’s financial turmoil, are not expected to raise the federal funds rate until late this year at the earliest, and probably not until sometime in 2011.
That still leaves a big question for many Fed-watchers: If the Fed faces big losses on its portfolio, will it feel pressure to dump its holdings more quickly than it should? Alternatively, will it need to cover its costs by printing money and fueling inflation?
Bomfim said in an interview that the Fed is not likely to feel such pressure. For one thing, he said, the central bank has more than enough capital to cover potential losses. Short-term interest rates would have to soar from almost zero right now to 8 percent before the Fed might actually experience a net loss. Beyond that, Fed officials have emphasized that their primary goal is not to maximize the Fed’s profits but to stabilize the economy.
But Bomfim said the Fed could face a political risk if it doesn’t start to reduce its holdings, because it would effectively be transferring much of its income to banks in the form of higher interest payments on their reserves. Given the current unpopularity of banks in Congress, that could easily create a political backlash against the Fed.