Monday, August 3, 2015

The Fed's Massive Conflict of Interest


What explains the Federal Reserve's reluctance to raise rates today? The conventional wisdom is that the economy remains soft and inflation hasn't yet shown signs of increasing. While both of these points are to an extent true, the soft economy could well be at least partly due to the serious hit that retirees have taken to their portfolio of fixed income investments, including the near-zero income they've earned on their typical Certificate of Deposit portfolios for the past six years.

Meanwhile, the current administration continues to pile regulation upon regulation to hamstring healthy industries while doing little to encourage economic activity otherwise.

As for inflation, it clearly hasn't spiraled out of control as feared by many monetarists, including myself, although I will argue in a future post that the Fed has relinquished its control over the price level by implementing its recent policies of paying interest on reserves, driving the fed funds rate to near zero, and expanding excess reserves into the trillions (from a few hundred million dollars previously, skipping right past the billions.)

The Conflict the Fed Now Faces: Huge Losses When Rates Go Up

First, let me say that I'm not going to do the sort of research that needs to be done to accurately quantify my claims here. No one is taking this issue seriously yet, so that level of examination of the problem is not yet needed. Others will do it should this conflict finally be taken seriously.

It's sufficient to say that the Fed's current portfolio of long-maturity debt instruments will take a significant hit if they ever return short rates to a reasonable level of, say, 5%. On a long treasury, the hit could be on the order of 25% to 35% of the Fed's original purchase price. And if inflation were to head toward 5% the resulting 8% or so rate on long treasuries could drive the loss to well over 50% of their purchase price.

If we assume the Fed's portfolio has $3 trillion of long securities subject to just a 25% loss in value from their purchase price, the loss would be $750 billion. Now, the Fed has been making money for the past several years by means of a massive carried interest trade since they've effectively financed their long portfolio with funds bearing almost a zero cost, i.e., the fed funds rate. Again, assuming a $3 trillion portfolio yielding, say, 3%, would mean that they've been clearing almost $100 billion per year on their position.

Incidentally, one argument that could be made for the Fed's reluctance to raise rates the past few years it that they want to bank that $100 billion per year for as long as possible so that they have a defense against the criticisms they will receive  over their inevitable losses when they someday are forced to raise rates.

Interest on Reserves Will Aggravate the Losses

The conflict deepens when the relatively new policy of paying interest on reserves is considered. There are only two obvious ways to neutralize the impact of over $2.5 trillion in excess reserve in the banking system. The Fed can either drain them or pay banks to continue to hold them.

Obviously, if they attempt to drain the reserves, they will have to commence selling their massive long portfolio. Such an action would further drive down prices of the securities they still hold, deepening the losses described above.

More likely, however, the Fed will decide to continue paying banks to hold their excess reserves. Currently banks receive a nominal rate, 0.25% (1/4 of one percent) to hold the over $2.5 trillion in excess reserves. That still amounts to a cost to the Fed of over $6 billion a year, however. But if the Fed were to raise rates by 1%, to 1.25%, each increase of said 1% will cost the Fed $25 billion in fees they would have to pay the banks to continue holding their excess reserve balance. Otherwise, they would simply sell them in the fed funds market.

Of course, banks attempting to liquidate $2.5 trillion in reserves they don't need would drive the fed fund rate back to zero again. Therefore, the Fed absolutely must either drain those reserves or pay the banks a high enough rate to continue to hold them. Thus, a 5% funds rate would imply that the Fed must assume a $125 billion annual operating expense if they are to neutralize the current excess reserve balance.

Conceivably, the Fed could do a massive reverse repurchase operation wherein they would lock in a longer-term rate for a time, alleviating the initial impact on their income statement. That is, they might convince the banking system to hold, via a, say, one-year repurchase agreement priced at 1%, the Fed's security portfolio, thereby draining the excess position for a year at a cost of only $25 billion. However, if rates at the end of that year were, say, 5%, the cost of a repeat operation would put the cost up to the $125 billion level for the following year.

Conclusion

The Federal Reserve has created a situation, via the various QE's, that now saddles it with a massive conflict of interest should they need to raise rates. That conflict is comprised of two parts, both parts amounting to hundreds of billions of dollars each in conceivable costs to the Fed.

It would not be at all hard to conceive of a situation in which the Fed's long portfolio is $500 billion underwater all while they are paying the banking system over $100 billion per year to neutralize the excess reserve position they generated when purchasing that long portfolio. One would think that prospect has received some internal consideration when the discussion of raising the fed funds rate comes up.

What is surprising is the lack of any such consideration in the financial markets and the political world. This is especially ironic since it has been the U.S. Treasury's intent to lengthen the maturity of the public debt at this time of exceptionally low interest rates, and yet the Fed has effectively reversed that decision by implementing its massive QE's.

Sadly, the policy hasn't even worked out as intended, enriching bond investors, stock investors, art investors, and real estate investors, but doing little to get the economy and the job markets growing again. And yet it continues. Perhaps the above-described conflicts have more than a little to do with that?

5 comments:

Rod Everson said...

I realize much of what I write here is controversial and that it can also be confusing. I'd be happy to expand in the comments section if readers have questions. I'd appreciate that civility be maintained.

Anonymous said...

Why does the Fed really care if they have to liquidate securities at a loss? Their congressional mandate is to keep unemployment and inflation under control, not to make money.

Rapido said...

I don't find your comments controversial at all. Just the facts, madam, just the facts.

Yes, this is going to end very badly. My concern, however, is what actions should be taken today to deal with tomorrow's train wreck. I'm thinking the first step is to bring back Glass Steagall to draw a line in the dirt. Those banks who want to gamble in the Wall Street casino should be free to do so, as long as they lose their FDIC protection. Said another way, let's stop calling hedge funds, like Goldman, banks. If Goldman wants to play with its own money, more power to 'em. But not with my money.

Once we cross that bridge, the Fed can go back doing what it is supposed to do, i.e., be the bank for the banks.

bob paglee said...

Is the world economy now entering a deflationary period? Will the Fed need to keep rates at the current level forever to avoid one disaster or another?

Rod Everson said...

My apologies to those who commented. I thought I had email notification of comments set up but did not, so your comments spent nearly 3 weeks in limbo.

Bob Paglee: If you read the Monetary Policy Parts 1-6 posts I wrote recently, you'll find what I think is the way we got here and how we might restore the Fed's original monetary policy tools which were far more effective than what they've done recently, by the way.

Rapido: I agree, for what that's worth.

Anonymous: The Fed has remitted, to the Treasury, i.e., to the taxpayers, around $80 billion a year since they built this massive positive carry trade. Undoing it would likely cost them a great deal, on the order of hundreds of billions, and believe me, the Fed does not want to go hat in hand to Congress with an "Oops!, instead of sending you money, we need you to put a hundred billion or so in the federal budget for our operation for a few years."

The point I was making in the post was that the Fed has faced a clear conflict of interest, a monetary conflict now, not a legal one, when it comes to the decision as to whether or not to raise rates. Perhaps that goes a long ways to explaining their decision to continue to penalize savers for the past seven years?