By: Michael Kling
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.
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