The Federal Reserve’s exit from ultra-easy monetary policy still looks very far off—by most accounts, rate hikes will not begin for more than two years and asset sales for even longer. However, the exit strategy could matter for markets well before that point. Fed officials have said that they will consider the costs and risks associated with quantitative easing (QE) when deciding how long to continue their purchases, and one factor they will be looking at will be whether the program could “complicate the Committee’s efforts to eventually withdraw monetary policy accommodation.” Therefore, the exit strategy affects the QE call, and could matter for the bond market well before the actual exit begins.
The December Federal Open Market Committee meeting minutes and a recent research paper published by Fed economists highlighted one concern in particular: that the Fed’s unconventional policy actions could affect its financial strength as interest rates rise. The central bank faces two interrelated problems. First, it could experience capital losses when it begins to sell its portfolio of mortgage-backed securities (MBS). Fed economists estimate that realized losses would average about $20 billion per year in a baseline interest rate scenario. Unrealized losses—including losses on Treasury securities, which the Fed does not plan to sell—could peak at $125-225 billion. Second, as it begins raising rates, the Fed will need to pay higher interest on commercial banks’ reserve deposits. This will raise its interest expense and thereby reduce operating income.
Lower interest income and capital losses have no direct bearing on monetary policy—central banks are not designed for profit maximization, after all. But a relevant question for policymakers might be: could reduced financial strength affect the Fed’s ability to achieve its mandated goals of full employment and price stability? The answer to this question revolves around the elusive concept of central bank capital.
All central banks report some measure of capital, but their definitions are essentially arbitrary. Consider capital ratios, for example. For central banks with positive net worth, capital ratios are as high as 61% for Colombia and as low as 0.03% for Canada (Ueda, 2004)—such a wide range that it is not even clear what is being measured. The same goes for central bank ownership structures. The Federal Reserve System is technically owned by commercial banks in the U.S., and shares pay an annual dividend of 6%. Shares in the Bank of Canada are held by the Minister of Finance on behalf of the nation (Stella, 1997). Shares in the Swiss National Bank actually trade on the open market. The structures can differ so much because unlike stakes in private enterprises, these shares do not represent claims to residual profits of the institution. Central banks have shareholders and capital like commercial banks, but in reality they are simply an arm of the government.
From a purely economic perspective a central bank’s capital position is basically meaningless. Governments grant their central banks the right to issue the nation’s currency. Therefore, a central bank cannot be insolvent in the same way as a private company: it can always issue more currency to cover its obligations. For this reason, there are many examples in history of central banks that operated for long stretches with negative net worth. For instance, the central bank of Chile suffered losses totaling 11.3% of government expenditures in 1997, resulting from losses on capital inflow sterilization activities and an effort to recapitalize commercial banks. It maintained a negative capital position from 1997 through 2000 (Dalton and Dziobek, 2005; Ueda, 2004).
The Fed has not recorded an annual loss since 1915, but it regularly takes losses and draws down its capital. According to a 2002 Government Accountability Office (GAO) report, Federal Reserve Banks recorded weekly operating losses 158 times from 1989 through 2001, mostly due to exchange rate revaluations. Twice in recent history (1993 and 2000) the federal government has also tapped small amounts of Fed capital in order to temporarily improve deficits—with no impact on monetary policy implementation.
That being said, we can see two scenarios in which the Fed’s capital position could be relevant for reaching its monetary policy goals. First, public perceptions might matter. Even if the Fed does not actually need positive capital to conduct monetary policy, large losses (realized or unrealized) could risk damaging its perceived independence and raising inflation expectations. The Bundesbank’s recent decision to repatriate gold reserves from the U.S. is a good example of how public perceptions of monetary policy often differ from economic realities, and how even independent central banks do not operate in political vacuums.
Second, in the case in which the Fed’s operating income and capital both turned negative, it would be forced to request additional government funding, change the stance of monetary policy or take other steps to lower operating costs, e.g. require banks to hold more of its liabilities at zero interest (see Bindseil, Manzanares and Weller, 2004). For example, in order to improve operating income, the Fed could lower the interest rate paid on excess reserves, but this would affect financial conditions and possibly growth and inflation outcomes. Ueda (2004) argues that the central bank of Venezuela abandoned its monetary policy stance for similar reasons in the mid-1990s. Other researchers have found empirical relationships between central bank financial strength and inflation outcomes—likely because financial strength serves as a proxy for independence (Stella, 2008).
The mechanics of how the Fed would deal with any losses are relatively clear (see Carpenter, Ihrig, Klee, Quinn and Boote, 2013). The Fed remits any income to the Treasury after paying dividends to member banks, interest on its liabilities, other operating expenses, and after replenishing any shortfall in its capital position. If losses caused operating income to fall below expenses in any period the Fed would draw down its capital position temporarily and suspend remittances to the Treasury (GAO, 2002). It would only resume remittances once its capital position fully recovered (the Fed’s capital level is determined by the size of member banks’ capital and varies over time).
A pause in remittances to the Treasury—that is, a period of Fed operating losses—appears likely as long as the current QE operation continues for a few more quarters. According to simulations by Fed staff economists, if buying were to follow consensus expectations, remittances would fall to zero for four years in a baseline interest rate scenario. In a scenario in which rates are 100 basis points higher than the baseline, the Fed would pay no remittances for six and a half years. The Fed only maintains about $55 billion in capital, so a period of negative net worth could not be ruled out.
Except in extreme scenarios, the likely resolution to any capital shortfall would probably be time. The Fed would simply retain earnings until it returned the balance sheet to normal—even if that took several years. Another option could be issuance of special Treasury bills to drain bank reserves, like those used during the financial crisis. This would essentially transfer a portion of interest expense to the Treasury and improve the Fed’s net income (though these bills would be subject to the debt limit). Beyond that, a direct payment from the Treasury would be the simplest mechanism to recapitalize the Fed (it is unclear whether the Federal Reserve Act would allow the Fed to raise capital on its own through issuance of claims against future earnings).
Clearly none of these options are very appealing. But Fed officials might retort that any losses should be considered in light of the exceptionally large remittances to the Treasury in recent years. Plus, dealing with the exit process would be a good problem to have, as it would signal that the economy was returning to normal and the Fed’s efforts to avoid deflation were ultimately successful.
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