Michael Kling: “Former Fed Economist Hein: The Fed Would Flunk Its Own Stress Tests” – Money News

Posted on :Apr 22, 2014

By: Michael Kling

Money News

April 22, 2014

The Federal Reserve has exposed itself to massive interest rate risk, warns  Scott Hein, a former St. Louis Fed senior economist.

In fact, if it was  a commercial bank, it would probably flunk its own stress tests, Hein writes in  an article for the American  Banker.
Its quantitative easing program (QE), which  entails borrowing short term to purchase huge amounts of long-term bonds, has  created that severe risk, explains Hein, now at Texas Tech University.
“If a top-30 bank had that kind of risk on its balance sheet, it would be taken  to task by examiners and shunned by investors,” he notes

Previously, the  Fed would create reserves to finances its purchases. Banks would then use those  reserves to support new deposits created when making new loans.

With  QE, the Fed began paying banks a 0.25 percent rate on its reserves, essentially  buying reserves to pay for its QE purchases, Hein explains. “As such, it is  operating like any other bank today, buying funds from one part of the economy  and lending them to another.”

It’s been hugely profitable for the Fed.  It’s paying 0.25 percent on the reserves used to the buy the assets that are  earning about 3 percent.

However, the scenario seems a lot like the  savings and loans crisis in the 1980s, Hein cautions. The S&Ls used  short-term loans to provide 30-year fixed-rate loans to homeowners.

“As  with the Fed today, this strategy was initially profitable. However, when  interest rates began to rise, the losses quickly piled up. The Fed today is  exposing itself to similar financial losses should interest rates rise.”

The Fed has said short-term rates will remain low for an extended period, but  it hasn’t done a good job forecasting the economy, Hein notes. For instance,  short-term interest rates fell much more than expected after the financial  crisis and stayed low much longer than expected.

“The markets and the  Fed were wrong in their earlier forecasts, and they could be wrong again,” he  warns. “An end to the ill-advised quantitative easing program can’t come soon  enough.”

A recent San  Francisco Fed study agrees the Fed could “incur significant  declines in bond values and net income when interest rates rise.” Any losses  should be manageable, however.

Top Fed officials are aware of the  issue. Minutes of the December 2013 Federal Open Market Committee meeting noted  “concerns about potential reputational risks to the Federal Reserve arising from  any future capital losses,” the report reveals.

Gold Goliath is not your typical gold dealer.

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