The Federal Reserve released a paper recently that has a lot of people talking.Titled “The Federal Reserve’s Balance Sheet and Earnings: A primer and projections,” the report dives into one of the most contentious questions currently surrounding Fed policy: as the central bank purchases more and more bonds through quantitative easing and its share of the market increases, what is its plan for an exit?
One of the big conclusions in the report is that if rising interest rates force the Fed to take losses on its massive bond portfolio, it could be forced to suspend the regular payments it remits to the Treasury – the interest income the central bank earns from the securities on its balance sheet.
The Fed said as much in the minutes from the December FOMC meeting, which included the sentence, “Depending on the path for the balance sheet and interest rates, the Federal Reserve’s net income and its remittances to the U.S. Treasury could be significantly affected during the period of policy normalization.”
The new report puts a price tag on those losses. According to the paper, if the Fed purchases around $1 trillion of bonds in 2013 – exactly as the market expects it to – the central bank will likely be forced to suspend remittances to the Treasury between 2015 and 2019, with peak unrealized losses on its bond portfolio reaching $250 billion.
Deutsche Bank strategist Stephen Abrahams released an analysis of the Federal Reserve paper today. In his note to clients, he points out that “unrealized losses diminish over time as securities mature, prepay or are sold.”
However, those unrealized losses could pose a nasty political problem for the Fed, writes Abrahams (emphasis added):
These or similar projections almost undoubtedly went before the Federal Open Market Committee in December. The minutes noted that the staff presented an analysis of QE focusing in part on the Fed balance sheet. One of the study authors, Jane Ihrig, attended the meeting, although the minutes do not say whether she presented the staff analysis or participated in the discussion.
The possibility of suspending remittances and carrying unrealized losses could complicate the Fed’s relationships with the rest of Washington and the public. While remittances help the federal government pay down debt, any shortfall in operating income leading to a suspension of remittances would require the Fed to borrow from Treasury.
And while unrealized losses have no effect on Fed operations because of the way government accounts for them, they would leave a private company technically insolvent. It is unclear how Washington and the public might react to these circumstances and whether the Fed’s independence might be challenged.
Abrahams calls the combination of the language in the December FOMC minutes and the contents of the Fed’s report “arguably the Fed’s first move to prepare the public for the potential costs of QE.”
Furthermore, if concerns over the costs of QE rise, Abrahams says, the Fed could consider three alternative courses of policy action:
- The Fed could scale down or suspend asset purchases before it has seen the improvement in labour markets that it might otherwise want
- The Fed could try moving its MBS purchases to higher coupons with shorter durations to mitigate the impact of higher rates on future asset sales
- The Fed could hesitate to raise rates or sell assets in an effort to manage either remittances, unrealized losses or both
Abrahams says any of these diversions from the current course of policy could cause inflation expectations to rise as the public realises that the Fed is becoming increasingly constrained in its options for exiting QE and loses confidence in the central bank’s ability to manage a smooth transition.
Finally, the Deutsche Bank strategist issues a warning to investors: “While the Fed looks likely to stick to its QE script in the near term, concerns about the costs of exit are likely to get louder over time. That raises the possibility of surprises in the course of QE. Investors should look at the parts of their portfolio most sensitive to the assumption that QE continues smoothly through 2013 and take some of that exposure off the table.”
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