The Fed's job just got more complicated

As of last quarter, the Fed had losses of US$66.5 billion (S$91.2 billion) in its securities holdings, while its capital stands at US$39.1 billion.
As of last quarter, the Fed had losses of US$66.5 billion (S$91.2 billion) in its securities holdings, while its capital stands at US$39.1 billion.PHOTO: REUTERS

WASHINGTON (BLOOMBERG) - According to its most recent financial report, the US Federal Reserve is insolvent. That is, its net worth is negative: As of last quarter, the Fed had losses of US$66.5 billion (S$91.2 billion) in its securities holdings, while its capital stands at US$39.1 billion.

That may be ironic for an institution tasked with ensuring that major banks have sufficient capital to maintain solvency in a crisis. From a financial perspective, that's not really a problem for the Fed - it can always print the cash as it needs. From a political perspective, however, the Fed could be vulnerable.

Some history: During the Great Recession, the Fed bought more than US$4 trillion in US Treasury bonds and related government debt - its so-called quantitative easing programme - which count as assets on its balance sheet. The corresponding liabilities are reserve deposit accounts that commercial banks hold with the Fed.

Until 2015, the Fed paid very little interest on reserve deposits but collected interest from its holdings of securities. These profits, amounting to billions of dollars, were regularly distributed to the Treasury.

Now the Fed is raising interest rates, and that hits its balance sheet in two ways. First, it has to pay higher rates on reserve deposits. Second, the rising rates lower the market value of the Fed's bonds.

Just as the extra profits that the Fed earned on its portfolio went to the Treasury, any losses it incurs fall to the Treasury. In normal times, this isn't a big deal; the Fed is not required to ask the Treasury for the money to make up those losses. The Fed can simply wait until it makes the money back through its normal operations.

If another financial crisis were to strike before then, however, the Fed could find itself in an awkward position. With interest rates so close to zero already, the Fed could not stimulate the economy very much just by cutting rates. It would almost certainly want to restart its quantitative easing programme.

 
 
 

But if the Fed is still technically in debt from its last quantitative easing programme, then it's bound to face scrutiny if not opposition from the public and from Congress. Much of the Fed's power stems from it being able to act decisively in times of crisis. Public mistrust and potential congressional opposition would undercut this ability.

That would be devastating. Financial institutions would be unsure how much support the Fed could provide to markets, and for how long.

That's why the Fed needs to wind down its stock of assets and rebuild its capital buffer quickly - but not too quickly: A rapid selloff can itself trigger a crisis, as the Fed learned in 2013's so-called taper tantrum. The Fed has since committed to selling off assets at a slow and steady pace.

It's a difficult balance. That, at least as much as any criticism he might receive from the president, is why Fed Chairman Jerome Powell is deserving of some sympathy - from the public and from Congress.