Intro to the Fed
The Federal Reserve is the central bank of the United States and acts in conjunction with the Treasury and other department branches to control the monetary supply. Composed of 12 banks for different geographic regions of the US, the Fed was founded by the US Congress in 1913 to alleviate financial disturbances (ie. limit the cyclical boom-bust nature of unregulated markets).
The Fed plays both a regulatory nature in limiting risk and conducting/settling transactions as well as controlling the monetary supply and interest rates. The Fed has two branches:
- The Federal Reserve Board of Governors who sets the reserve requirements for fractional reserve banking and the discount rate on loans to member institutions (usually to meet reserve requirements).
- The Federal Open Market Committee (FOMC) meets 8 scheduled times a year (the next being March 16) and determines monetary policy such as interest rates through open market operations. The FOMC is composed of the Board of Governors, which has seven members, and five Federal Reserve Bank presidents. They also enact policies to control the federal funds rate (overnight lending rate between member institutions). In certain circumstances, the FOMC also expands OMO to Quantitative Easing, where they buy assets beyond short-term government treasuries.
How the Fed Makes and Loses Money.
Although the Fed makes some profit maintaining currencies for settling transactions between nations and foreign government bonds, interest on loans to other institutions, and conducting financial services, the Fed has traditionally made money from the yield spread on government securities. Since the Fed can print money with negligible expenses and earn a yield on this by buying loan assets, the Fed can use this profit to pay interest on its reserves. It can also make money from selling securities it owns, but this is unlikely to occur as a profit, as will be discussed later on. Any profits the Fed makes after paying out interest on its reserves are passed to the Treasury.
Here, the Fed might seem like a money making machine, and in fact, it has produced massive profits for the Treasury in the past year, passing tens of billions annually back to the Treasury as remittances.
Why the Fed Is at Risk
It would seem that as the central bank and with its printing press, the Fed would have a near monopoly on yield spreads and interest rates to US institutions. This would be true if the Fed’s goal was profit, and it didn’t play a role in the American economy.
Following QE, the Fed has bought more than $6 trillion in long-term bonds (amazingly some of these bonds are even corporate following Covid-19, which provokes interesting questions about Fed accountability), meaning the Fed has a humongous long position in long-term loans/rates. By providing interest on its reserves, the Fed automatically has a short position on short term rates (although T-bills do offset this somewhat). In terms of historical cost accounting, as long as the Fed holds its loans to maturity (assuming that the borrower does not go insolvent), the Fed will make a profit on its loans, since it accounts these loans as assets at their full expiry values on its balance sheets. Although the Fed claims it plans to do this, in actuality, this is near impossible.
Nevertheless, the picture is different in terms of market accounting if interest rates continue rising. If the Fed attempted to sell these low interest yielding loans on the market, they’d have to offer them at a steep discount because long term interest rates have risen and are continuing to rise against the originally lower yields of the Fed’s assets (of course, some of these assets come from 2008 and would surprisingly be higher yielding). After all, why would an investor want one of the Fed’s assets when they can obtain a better return on the open market? Thus, in terms of market rates, the Fed is sitting on a massive, and growing, loss.
Now investors must ask, why would the Fed be motivated to raise short term interest rates (or allow any part of the yield curve to rise) if it would make its assets lose value. Much like Japan has done for decades, why couldn’t the Fed perpetually maintain a low interest rate environment?
After all, highly leveraged, the Fed can quickly find itself in snowballing debt in terms of market accounting if it ever had to sell its assets in a high interest rate environment.
Why the Fed Will Be Forced to Raise Interest Rates
Currently, the market is pricing in rapid inflation, and as we’ve said many times, narratives in the market are self-perpetuating. If investors believe inflation will occur, they will logically pour their fiat into inflation-linked assets like stocks, which will cause prices to bubble even further. This logic extends to households as well, where individuals are incentivized to take advantage of easy credit and low savings rates to spend today because their money will be worth less tomorrow.
To control it, Powell will be forced to decrease the monetary supply and increase interest rates: selling toxic assets that will flood the supply in an already higher interest environment, meaning they will sell for loss, and the Fed will take a big loss. Although Powell has other tools to manipulate inflation (see the previous post), with banks being currently reluctant to lend, the Fed will eventually have to either imply it will or actually raise rates. Powell has already admitted that some inflation is on the horizon (although claimed it will be short term).
As we can see below, American production is no longer at a steep deficit compared to January 2020 (which was before Covid19’s effects truly hit). Then, how would Powell make inflation short term while monetary velocity can only conceivably increase without miraculously increasing American production dramatically? The short answer is decreasing the Fed’s $6 trillion in assets on its balance sheet by selling them.
During Covid19, to incentivize banks to take in more deposits and loan out more of their money, the Federal Reserve lifted the Supplementary Leverage Ratio restriction from including US Treasuries and Reserves as part of a bank’s capital exposure. The SLR is calculated as the banks capital on hand(common equity capital)/ total exposure and set to 3–5% depending on the type of bank. Banks were thus incentivized to accept more deposits and buy safe Treasuries to make a meager (but incredibly safe yield) during the recession. Of course, the actual plan was for banks to extend loans to companies, but the reality is questionable.
Cons for the Federal Reserve
- Banks would possibly refuse deposits (which act as liabilities to the bank) to maintain their SLR (odds of it happening are minuscule because banks are inherently profit-seeking). Banks would possibly raise further capital through an equity round, but this too is questionable.
- Banks would sell treasuries (likely), which would raise interest rates. Banks are estimated to have about $600 billion more in treasuries than their historical trends would indicate, so there might be huge selling pressure. Nevertheless, banks are overwhelmingly and increasingly long on treasuries, but this could be a hedge against deflation/market crashes because in rising interest rate environments, banks stand to make more in profits.
3. Treasuries/Reserves are backed by faith in the US gov, so they’re incredibly safe and not a real danger as part of the supplementary leverage ratio, meaning the Fed would be doing it more for semantics than risk control
4. If interest rates go up, the Fed’s assets will be worth less, so the Fed would likely rather be the first seller
5. The higher interest rates might shock the stock market
Pros for the Federal Reserve:
- It prevents the Fed from having to sell its assets at a loss immediately, and even continue QE to buy treasuries (which investor narrative wise might be more important). If the Fed announced plans to stop QE, it would mark a significant shift in Fed policy, much more so than re-enacting the SLR ratio limit.
- The Fed anyway has to raise interest rates to curb inflation, so it might as well start with something small to indicate its position without causing a massive shock. Furthermore, one of the Fed’s primary aims is preventing market bubbles (it was originally conceived to less boom-bust cycles), so the Fed has a duty to curb dangerously frothy investor sentiment.
- It is politically expedient since the Fed appears to be taking a stand against Wall Street and big banks.
- Provides test run of how the market will react to unloaded treasuries
- The big banks are unlikely to immediately flood supply (since this would make them get worse fills). However, the stimulus packages will occur as a lump sum payment, so the off-loading of treasuries (raising interest rates) could help negate inflation.
- The Fed doesn’t care about losses (essentially)
- If the Fed doesn’t increase supply of treasuries, Americans might soon face negative short-term interest rates on their deposits(as compared to negative real interest rates) on their deposits, which can spark a crisis of confidence and a severe bank run.
In the long term, it doesn’t matter which way the Fed decides to vote on reinstating the SLR goes, because eventually the Fed will be forced to release rates to curb inflation as monetary velocity rises (and the monetary base remains at large). Even Powell has admitted that the Fed will likely make losses in the future, but the caveat is that the Fed simply doesn’t care since its USD losses can and (practically) will always be covered. No matter what, investors should avoid finding themselves trading on the opposite side of the Fed since the Fed is one of the only American institutions that cannot run a loss, so it can manipulate any investor out of the markets.
Who Will Cover the Fed’s Losses?
If the Fed makes a loss, the Treasury will cover the first $454 billion losses in the CARES act of 2020 (the CARES act was coincidentally paid for with dollars from the Fed printed for treasuries), but the Fed can anyway receive a gift of T-bills from the Treasury to cover its losses, which would make the Fed’s loss part of the public’s debt. To avoid this PR nightmare, the Fed now writes negative interest on Federal Reserve Notes due to US Treasury to avoid asking for a bailout. If the Fed makes a loss in a year, it will simply pause remittances until it is back in the green.
Can the Fed Go Broke?
As shown before, even if the Fed makes several bad economic decisions, so long as most of its debt is in USD and not in assets that are tied to inflation (such as stock indexes), it can simply print itself out of debt. Thus, following MMT it is nearly impossible for the Fed to go broke. However, if the Fed is making considerable losses, it might degrade the Fed’s credibility, which could have long-term complications for its ability to manipulate monetary policy and erode confidence in the dollar.
