Fed Should Read Its Own Memo

Fed Should Read Its Own Memo on Rising-Rate Risk: Caroline Baum

Commentary by Caroline Baum

Jan. 20 (Bloomberg) -- Bank regulators, in an effort to buff up their tarnished image and appear proactive, took it upon themselves to alert their charges to looming interest-rate risk.

“In the current environment of historically low short-term interest rates, it is important for institutions to have robust processes for measuring and, where necessary, mitigating their exposure to potential increases in interest rates,” sayeth the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Federal Reserve and other regulators in a Jan. 8 Interagency Advisory Bulletin.

It’s no surprise interest rates are going up. They can’t go any lower. The Fed’s benchmark rate has been close to zero for more than a year.

Are regulators reading their own memo? Rising interest rates introduce a new kind of balance-sheet risk for the Fed. With $1.2 trillion of variable-rate liabilities and $2 trillion of fixed-rate assets, when rates rise, the Fed’s net interest margin shrinks. What would happen if it disappeared?

Raymond Stone, chief economist at Stone & McCarthy Research Associates in Skillman, New Jersey, looked at the limits to the size of the Fed’s balance sheet in a Dec. 15 research report. Here are the key points:

Right now, the Fed is earning about 4 percent, or $80 billion a year, on its fixed-rate assets, consisting primarily of U.S. Treasury, federal agency and mortgage-backed securities. For the first time ever, the Fed is paying interest (0.25 basis points) on bank reserves, the deposits banks hold in their accounts at the Fed or as vault cash.

Currency Was King

Prior to September 2008, currency in circulation was the Fed’s main liability and cost nothing. Its chief asset was Treasury securities. So the Fed clipped coupons, reinvested the proceeds from maturing securities at prevailing interest rates, paid a small amount of interest on things like reverse repurchase agreements, and turned over the bulk of its profit to the Treasury, as required by law.

Last week, the Fed reported record net income of $52.1 billion for 2009; it earned a bundle on the money it created. After operating expenses and interest on reserve balances, the Fed remitted $46.1 billion to the Treasury.

The Fed has always been self-financing, which Stone says underpins its independence. Just imagine if the central bank had to go to Congress for an annual appropriation. By the time those folks got done horse-trading earmarks, the Fed’s appropriation might look like a transportation bill.

No T-Bills

The Fed no longer owns many Treasury bills, so the asset side of its balance sheet won’t benefit from reinvesting in higher yielding securities as rates rise. It will still be earning about 4.5 percent on all those mortgage-backed securities even as it pays higher interest rates on reserve balances.

With $2.2 trillion in assets, it would take a 7 percent funds rate for the Fed’s variable interest expense to overwhelm interest income, Stone calculates. The bigger the portfolio, the lower the break-even rate.

The Fed is scheduled to wind down its $1.25 trillion MBS purchases by the end of March, but at the Dec. 16 meeting policy makers discussed extending the program if the economy weakens, according to the minutes.

“They have to realize they would be boxing themselves in,” Stone says.

As the net interest margin shrinks, the less inclined the Fed would be to raise interest rates and the more unhinged inflation expectations would become, he says.

Political Meddling

The Fed is already fending off increased meddling from the political classes. The House of Representatives passed a bill that would open the door to government audits of monetary policy decisions. New financial regulatory legislation before Congress would clip, or eliminate, the Fed’s supervisory authority.

The shrinking of its net interest margin isn’t the only box the Fed finds itself in. As the buyer of last resort for agency MBS, the Fed has “supported the housing-market stabilization policy of the Obama administration,” David Kotok, chairman and chief investment officer of Cumberland Advisors Inc., a money manager based in Vineland, New Jersey, wrote in a recent paper. The effect has been to subsidize homeowners at the expense of taxpayers, which is not a traditional role for a central bank, he says.

The Fed and Treasury purchased a combined $1.3 trillion of agency MBS last year, 76 percent of the gross issuance (including refinancings) and more than three times the net increase in the size of the market. Analysts estimate the effect lowered mortgage rates by about 75 basis points.

Ranking the Concerns

When interest rates rise, the Fed will incur capital losses on its securities if it decides to sell them. If it doesn’t sell them, or isn’t successful in locking up banks’ excess reserves, inflation will be waiting behind Door No. 2.

Stone admits it may be premature to worry about the Fed’s net interest margin at a time of record profitability. On a scale of 1 to 10 of things to worry about, with 1 being long- term unemployment and 10 being the sun going dark in 5 billion years, I’d give it at least a 4.