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The Federal Reserve’s USD9 trillion balance sheet poses significant risks to taxpayers because even unrealized losses from rising interest rates might translate to a multi-year cessation of Fed remittances to Treasury, which currently provide tens of billions of dollars in annual revenue, former Fed board economist Bill Nelson told MNI.
Fed officials have tended to downplay the effects of potential fluctuations in its own financial position on the economy. But while the conduct of monetary policy is unlikely to be affected, Nelson said the cost to taxpayers would be real.
“Those losses are really just as consequential whether they’re unrealized or realized in terms of the outlook for future Fed income,” said Nelson, former deputy director of monetary affairs at the Fed’s board and now chief economist at the Bank Policy Institute, in the latest edition of MNI’s FedSpeak podcast.
“If the Fed’s income falls then it will be remitting less to Treasury, and taxes, other things equal, will have to be higher, or spending will have to be lower. So those are real effects.”
The extent of the impact will depend on the Fed’s own policy– in particular, how high interest rates rise in this cycle and how quickly the balance sheet is unwound. (See MNI: Fed QT May Have Deeper Tightening Effect - Ex-Officials)
“When interest rates rise the Fed’s interest expense rises but its interest income, which is largely based on fixed assets, doesn’t rise, so that operating income can turn negative,” said Nelson, adding that this could occur once the fed funds rate hits around 3.5%.
A baseline projection for the fed funds rate to peak at 2.6% included as one of three scenarios in the New York Fed’s annual report in May was based on March projections that were already outdated, Nelson said.
“Probably as a reference point to where we are now approximately the plus-100-basis-point scenario is a bit more relevant than their baseline and the plus-200-basis-point scenario is a reasonable alternative,” Nelson said.
Under the +100bps scenario, which would see the fed funds reach 3.6%, the New York Fed estimated unrealized losses would peak at USD770 billion, while in the +200bps case unrealized losses would peak at about USD1.2 trillion.
The first of these scenarios would lead to zero remittances to Treasury for a year and a half, while the second would mean no remittances for three years. That’s in sharp contrast to the last couple of years: the Fed sent Treasury USD109 billion in 2021 and USD87 billion in 2020.
“Those are some pretty big numbers,” said Nelson. “When those unrealized losses go up that means future taxes are going to be higher or future spending is going to be lower.”
Possible sales of mortgage bonds as the Fed tries to reduce its role in the housing market could further complicate the central bank's financial position.
BENEFITS VS. COSTS
The prospect of losses to taxpayers does not in itself mean the Fed’s decision to launch a fourth round of QE in response to the pandemic was a bad idea, Nelson said.
“I look at the actions in March and April, when the Treasury market was at risk of collapsing and those purchases seemed clearly beneficial. But then that program morphed over time into an economic stimulus program at a time when the economy was clearly recovering, so the gains and the calculus seem less clear,” he said.
The losses in no way affect the Fed’s ability to conduct monetary policy, Nelson said. But he worries the potential costs of such action are underappreciated.
“What the Fed is doing when it engages in QE is shortening the government’s liabilities,” he said. It’s replacing longer-term borrowing with overnight borrowings. When it does that it that changes the risk the U.S. government is facing.”
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