December 15, 2010 10:56AM

Is the Federal Reserve Heading Towards Insolvency?

A recent statement from the Shadow Financial Regulatory Committee, points out that both rounds of quantitative easing by the Federal Reserve have dramatically altered the maturity structure of the Fed’s balance sheet. Normally the Fed conducts monetary policy using short‐​term Treasury bills, which allows the Fed to avoid most interest rate risk. In loading up its balance sheet with long‐​dated Treasuries and mortgage‐​backed securities, the Fed has exposed itself to significant interest rate risk.

Recall that the yield, or interest rate, on a long term asset is inversely related to its price. So if you’re holding a mortgage that yields 5% and rates go up to 6%, then the value of that mortgage falls below par. The same holds for Treasury securities. I think it is a safe assumption that rates will be higher at some point in the future. When they finally do rise, and if the Fed still maintains a large balance sheet of long‐​dated assets, those assets will suffer losses.

Of course the Fed is not subject to mark‐​to‐​market rules and can avoid admitting losses by holding these assets to maturity. But if the Fed, at some point in the future, wants to fight inflation, the most obvious way of doing so would be to sell off assets from its balance sheet. It is hard to see the Fed engaging in substantial open‐​market operations without using its long‐​dated assets. But if it is to sell these assets, it will have to do so at a loss (once again, because of higher rates).

Now the Fed claims to have other avenues by which to tighten, besides open‐​market operations. For instance, it can raise the interest rate on excess reserves. But then this would further erode the value of assets on its balance sheet. Not to mention that they have to find the money somewhere to pay these higher rates on reserves.

Ultimately the Fed can continue to pay its bills, not out of earnings from its balance sheet, but by electronically crediting the accounts of its vendors and employees, but that would also be inflationary. The real danger, again pointed out by the Shadow Committee, is that the Fed may avoid raising rates in order to minimize the losses embedded in its balance sheet. One of the very real dangers from QE1 and QE2 is that the Fed has exposed itself to potential losses that are correlated with any efforts to fight inflation, raising serious questions as to its willingness to fight inflation.