Fed faces explaining billion-dollar losses in QE exit stress

Policy Grip

Four economists, including Frederic Mishkin, a former Fed governor and co-author with Bernanke, argued in a paper presented in New York on Feb. 22 that the central bank’s grip on policy may weaken if losses coincide with high U.S. budget deficits and an inability of Congress and the White House to put fiscal policy on a sustainable path.

“This mix could induce a bias toward slower exit or easier policy, and be seen as the first step toward fiscal dominance,” the economists said in the paper, presented at the U.S Monetary Policy Forum, referring to fiscal influence on monetary policy. “It could thereby be the cause of longer-term inflation expectations and raise the risk of inflation overall.”

In response, Fed Governor Jerome Powell said at the conference that policy makers “have the flexibility to normalize the balance sheet more slowly” to avoid taking losses and causing market disruptions. He said there’s “no reason” to expect the Fed won’t act to prevent inflation.

Policy Trade-Offs

Boston Fed President Eric Rosengren said that “this discussion does not do justice to the policy trade-offs” of the central bank’s quantitative easing, because the stimulus boosts growth and also improves the fiscal outlook by lowering borrowing costs.

Now, it’s Bernanke’s turn to convince lawmakers.

“When they start losing money -- that is going to be a big issue” on Capitol Hill, said Hester Peirce, a former senior counsel to Republican staff on the Senate Banking Committee who is now a senior research fellow at the Mercatus Center at George Mason University in Arlington, Virginia. “There will be more pressure to watch the Fed closely.”

Bernanke is implementing the most aggressive monetary policy in the central bank’s history to support growth and employment. After the Fed’s benchmark rate was cut to a range of zero to 0.25 percent in December 2008, the chairman began buying more bonds to lower longer-term financing costs for home buyers, companies and consumers.

Total Assets

Three rounds of quantitative easing, including the current phase where the Fed is buying $85 billion in longer-term Treasury bonds and mortgage-backed securities a month until the labor market shows substantial improvement, have pushed the Fed’s total assets to more than $3 trillion, from $869 billion in mid-August 2007 when the financial crisis began.

Fed officials say the portfolio’s size and even potential losses are a byproduct of its pursuit of stable prices and maximum employment, the two policy goals mandated by Congress.

At the same time, they have encouraged the public to view the portfolio in profit-and-loss terms by emphasizing its earnings in recent years. Officials in conference calls with reporters describe how returns on the expanding balance sheet have generated higher profits that the Fed gives back to taxpayers in the form of remittances to the U.S. Treasury. Vice Chairman Janet Yellen, in Feb. 11 remarks in Washington, said the strategy benefits the economy as well as federal finances.

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