R. Christopher Whalen
Jul 24, 20226 min
Updated: Jul 25, 2022
July 25, 2022 | Premium Service | As the meeting of the Federal Open Market Approaches this week and, more important, Camp Kotok begins next week, we have more than a few questions for Chairman Jerome Powell and his colleagues. A careful reading of the Fed’s research provides some insights about future Fed policy. Since the May 2022 statement regarding the management of the system open market account or SOMA, there have been a couple of important pieces of research that are suggestive regarding future policy. H/T to Bill Nelson at Bank Policy Institute.
Two research reports by the Fed of New York have illuminated both the history of the Fed’s SOMA portfolio and then project forward the likely losses by the Fed as the portfolio gradually shrinks. More, the second paper by Alyssa Anderson, Philippa Marks, Dave Na, Bernd Schlusche, and Zeynep Senyuz, sets some disturbing markers for the future size of the SOMA portfolio and the realized and unrealized losses that are likely to accumulate.
Totto Ramen East (2019)
In the second FEDS Notes paper, the authors explain how the Fed is likely to start to generate actual, realized losses because of the interest rate mismatch on the Fed portfolio. This is more than a little amusing and also terrible to behold. The FRBNY paper essentially highlights one of the biggest downside risks created by quantitative easing or “QE,” namely a gigantic interest rate mismatch across the market for banks, non-banks and other financial intermediaries including the GSEs. Thus in the final paragraph, the Fed drops a bomb:
“While the expansion of the Fed's balance sheet in response to the pandemic may have increased the risk of the Fed's net income turning negative temporarily in a rising interest-rate environment, the Fed's mandate is neither to make profits nor to avoid losses. In all its actions, the Fed seeks to achieve its congressional mandate of maximum employment and stable prices. If the Fed had not taken these actions, the risk of experiencing a period in which net income turns negative would be lower than it is at present, but the economic position of households, businesses, the U.S. government, and taxpayers would be far worse off.”
Of course, the Fed has the luxury of ignoring losses because, as a creature of the US Treasury, it’s resources are assured. But private financial intermediaries and banks don’t have this luxury. As this edition of The Institutional Risk Analyst went to press, there were literally hundreds of billions in unrealized losses on the books of private investors, banks, all three GSEs and money market funds, underwater paper that will likely be retained through to maturity, reducing bank net interest margins.
Apparently this is precisely what the Fed intends to do, namely keep all of the low coupon paper in the SOMA until it matures, in some cases decades from now. Thus the FRBNY paper projects likely realized losses from the difference between what the Fed earns on its portfolio and what it pays out to reserve holders and participants in the Reverse Repurchase (RRP) facility reaching $180 billion in a stressed scenario.
Importantly, the paper assumes that the Fed will not realize any market losses on the SOMA. This suggests that there will be no outright sales of either mortgage-backed securities or Treasury paper in the SOMA. Is this now Fed policy? Somebody should ask Chairman Powell.
The other big takeaway from the FRBNY paper is that the portfolio is going to be allowed to decline to about $6 trillion by 2025 and then start to grow again back to $8 trillion by 2030. This suggests a vast increase in the Fed’s monetization of debt service costs for the Treasury as rates increase.
The enormous magnitude of losses on the Fed’s interest rate mismatch may prevent the central bank from making any remittances to the Treasury for several years. We can look forward to the eventual reduction of the RRP facility by raising the rate paid on reserves but not the rate for reverse RPs. Later this year, as short term rates rise, the Fed will force banks, money market funds and other investors out of RRPs.
Media note: Somebody ask Chairman Powell about the timing of the “tapering” of the RRP facility, now $2.2 trillion. Think of the SOMA and RRPs as the asset side of the Fed’s ledger, while total bank reserves are the increasingly costly source of funding. The interest rate mismatch on the Fed’s balance sheet will give economists something to talk about at Camp Kotok, but for private lenders and investors, the legacy of QE may be capital losses and bankruptcy.
Importantly, Bill Nelson notes that the elevated capital requirements for banks via the Supplementary Leverage Ratio (SLR) have had the unintended consequence of driving banks into the RRP facility. He wrote last week:
“Eventually, prior to reserve balances declining further than the Fed wants, the Fed will need to widen the spread between the IORB rate and the ON RRP rate to drain the facility. Seems unlikely that the Fed will take that step at the July meeting, though. Money market rates have been low relative to the target range, so raising the ON RRP by only 70 basis points Wednesday could leave them below the target range. Raising the IORB rate 80 basis points could shine a brighter light on the expense of such a big balance sheet. Better to just wait a bit longer.”
These most recent posts from the FRBNY research staff have clarified earlier Fed statements about the impact of unrealized losses on the SOMA. The authors of the FRBNY paper conclude:
“While an unrealized gain or loss position on the SOMA portfolio does not directly affect the Fed's net income, if a higher expected policy rate path causes an unrealized loss position, this would be indicative of higher future interest expense. [fn] A higher policy rate path means that the Fed will have to pay more on its liabilities such as reserves held by banking system and the ON RRP facility.”
Of note, Bill Nelson and Andy Levin of Dartmouth will be presenting our a new paper (“Quantifying the Costs and Benefits of QE”) at a Hoover workshop Wednesday July 27. He notes that whether the Fed loses money on asset sales or interest rate mismatch, the losses will occur:
“As I explained in a blast email in May here), the correspondence between unrealized losses and expected future remittances is, in fact, pretty tight. In particular, a change in unrealized gains/losses over an interval resulting from a change in the expected policy path is approximately equal to the change in the expected present value of future remittances.”
Or to put it another way, past Fed statements have made it seem that outright sales of securities were being contemplated, which in turn would result in realized losses to the Fed and massive disruption to the secondary loan market for mortgages. Instead, this most recent missive seems to confirm that there will be no outright sales of securities from the SOMA, but the Fed will realize actual losses due to the asset/liability mismatch caused by rising interest rates.
Final media note: Ask Chairman Powell how he and the members of the Committee think about the interaction between the swollen SOMA, large bank capital levels and the target for Fed funds. We suspect that merely asking that question will force Powell to reveal his true thinking regarding inflation. But do any of the journalists in the audience have the courage to ask?
Specifically, after a modest reduction, the Fed plans to grow the SOMA and RRPs significantly to accommodate “reserve needs” (aka the federal deficit). The chart below comes from the FRBNY paper:
Once upon the time, the Fed funds rate was a private market. Today it is a tool for public policy. As the Fed continues to expand its balance sheet, albeit after a modest adjustment, the only conclusion for reasonable people is that the central bank has embraced inflation as its primary tool to finance federal deficits. The Fed will, if necessary, destroy and subsume the private financial markets in order to keep the market for new Treasury debt open and functioning.
The pursuit of the 50-year old dual mandate has become a threat to the stability of the US markets and the economy, a fact illustrated by the Fed’s actions over the past decade. Each time the Fed changes policy, greater volatility is seen in markets and throughout American society, as illustrated by housing.
When Congress passed the Humphrey-Hawkins law half a century ago, the America’s public debt was tiny and had little impact on Fed policy. Today, managing the Treasury’s debt is the Fed’s primary though unspoken task and explains the vast growth in the Fed's balance sheet. There has never been a better time for Congress to repeal the Humphrey-Hawkins law and refocus the Fed entirely on price stability.