Everyone wants the Federal Reserve to say how it will unwind the $3 trillion balance sheet amassed from years of quantitative easing.
Indeed, this was something of a hot topic in Fed Chairman Ben Bernanke’s testimony before Congress last week.
One of the big issues the central bank faces is the inevitable loss it will have to take when interest rates rise and the value of the Fed’s bond portfolio declines.
Although not an economic problem — as “losses” for a central bank are pretty meaningless — there could be a PR problem when the Fed stops making payments to the Treasury from the interest income it receives on its bond portfolio.
Deutsche Bank strategist Stephen Abrahams recently explained why this could be such a nightmare:
The possibility of suspending remittances and carrying unrealized losses could complicate the Fed’s relationships with the rest of Washington and the public. While remittances help the federal government pay down debt, any shortfall in operating income leading to a suspension of remittances would require the Fed to borrow from Treasury.
And while unrealized losses have no effect on Fed operations because of the way government accounts for them, they would leave a private company technically insolvent. It is unclear how Washington and the public might react to these circumstances and whether the Fed’s independence might be challenged.
The Fed appears already to be preparing for this problem. Below is the explanation Bernanke provided in his Congressional testimony:
Another aspect of the Federal Reserve’s policies that has been discussed is their implications for the federal budget. The Federal Reserve earns substantial interest on the assets it holds in its portfolio, and, other than the amount needed to fund our cost of operations, all net income is remitted to the Treasury. With the expansion of the Federal Reserve’s balance sheet, yearly remittances have roughly tripled in recent years, with payments to the Treasury totaling approximately $290 billion between 2009 and 2012. 6
However, if the economy continues to strengthen, as we anticipate, and policy accommodation is accordingly reduced, these remittances would likely decline in coming years. Federal Reserve analysis shows that remittances to the Treasury could be quite low for a time in some scenarios, particularly if interest rates were to rise quickly. 7
That’s the bad news with regard to remittances. Bernanke goes on, though, in an attempt to mitigate it:
However, even in such scenarios, it is highly likely that average annual remittances over the period affected by the Federal Reserve’s purchases will remain higher than the pre-crisis norm, perhaps substantially so. Moreover, to the extent that monetary policy promotes growth and job creation, the resulting reduction in the federal deficit would dwarf any variation in the Federal Reserve’s remittances to the Treasury.