Fed faces explaining billion-dollar losses in QE exit stress

‘Appearance Issue’

“I am concerned about this issue,” St. Louis Fed President James Bullard said in a Feb. 1 interview in Washington. Bullard advocates holding some remittances back in the form of reserves now to serve as a buffer against losses later. “The appearance issue is a serious one and we should take it seriously,” he said.

The practice of accounting for losses as a deferred asset is among questions congressional leaders are raising.

“I don’t think we will buy that,” said Republican Representative John Campbell of California, a certified public accountant who chairs a monetary policy subcommittee on the House Financial Services Committee. Fed portfolio losses are “a legitimate concern and something we will be watching.”

Fed officials say the portfolio losses should be viewed in comparison with the Fed’s cumulative remittances to the Treasury, which have totaled $448 billion over the past decade.

Staff Paper

In the past, officials have warned that they are taking on interest-rate risk, and a recent paper by Fed Board staff attempted to quantify how that would affect their payments to the Treasury.

The analysis led by Seth B. Carpenter, senior associate director in the Fed Board’s Division of Monetary Affairs, shows that, assuming another $1 trillion of bond purchases under the current quantitative-easing program, remittances to the Treasury will fall to zero for about four years under a baseline economic outlook with gradually rising interest rates.

The Fed’s portfolio had $249 billion in unrealized gains as of the end of September, according to the paper.

Under a more aggressive interest-rate increase scenario, remittances are halted for about six years, as “higher short- term interest rates make interest on reserves more costly, and higher long-term rates make selling MBS more costly,” according to Carpenter’s analysis.

Yellen Speech

“There is a chance when we could go through a period of time in which our income falls and we could even take losses if we decide to sell,” Yellen said in response to audience questions after a Feb. 11 speech. “It is possible that in the course of trying to carry out monetary policy that there will be a period of a year, or even several years, in which those remittances fall to zero.”

Minutes from their January meeting show “many participants” on the FOMC worrying about how to exit from the bond portfolio with “several” noting the Fed could be exposed to “significant capital losses.”

The Fed wouldn’t be the first central bank to lose money from its policies, said Nathan Sheets, formerly the Fed’s top international economist.

Central banks in Switzerland, Chile, Mexico have taken losses that did not prevent them from conducting monetary policy, he said.

There is also a good news side to the story as well, he added.

“It’s often thought that if you incurred a loss you made a mistake and didn’t handle resources properly,” said Sheets, now global head of international economics at Citigroup Inc. in New York. “In central banking that presumption is turned on its head,” Sheets said.

“If recovery occurs then bond prices may fall,” he said. “But it’s not a failure in your policy, it would reflect a success of your policy” as economic growth picks up and the Fed can finally stage an exit.

Bloomberg News

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