Fed QE exit: The Federal Reserve made $82 billion on its $2.4 trillion book of assets in 2010. That's in part thanks to the carry trade created by its own ultra-low interest rates. But with the next move inevitably upward, the Fed could find that fighting inflation dents its balance sheet.
The US central bank's book — now nearly three times as big as at the end of 2007 — is stuffed with mortgage-backed securities it purchased to help stabilize the housing market after the 2008 crisis and with US Treasuries, many of which were purchased since November to give a still flagging economy an extra push.
When inflation raises its ugly head - and some think it already has - the Fed will need to raise interest rates. But assuming that either causes or echoes market-driven rate increases at longer maturities as well, that will mean that whatever remains of the more than $2 trillion of bonds on its balance sheet will fall in value. To be fair, the Fed has had plenty of time to consider its exit strategy.
And on Wednesday, it said it would begin another round of tests of the so-called reverse repo mechanism intended to drain excess liquidity from the financial system without having to sell mortgage bonds and Treasuries. Moreover, its cost of finance would have to go much higher, perhaps to around five to six per cent on overnight rates, before its funding cost exceeded the interest it receives.
However, pressure to start selling its stash of bonds is sure to rise once the economy is on sturdier ground. If the Fed does that as interest rates are rising, it would end up selling some assets at lower prices than it paid for them. Last year Credit Suisse estimated, based on a bond selling pace of $100 billion a year, that short-term interest rates above 4.25 per cent would result in mortgage losses. Critics of the Fed’s recent actions would surely seize on that outcome. Rates above four per cent are not high to be implausible in an inflationary environment. It’s true the central bank has a luxury that regular banks don’t: it can book any losses against future earnings rather than against its slim $52 billion capital cushion. But for those observers sceptical of appetite of Fed Chairman Ben Bernanke for fighting inflation, it’s a worry that the main weapon is double-edged for the man wielding it.
