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Home Publications Blogs Beat the Press The Fed Becoming Insolvent: Things to Worry About After We're Dead

The Fed Becoming Insolvent: Things to Worry About After We're Dead

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Tuesday, 29 October 2013 15:29

If the economy were humming along at 3.0 percent growth and 4.0 percent unemployment it would be reasonable for economists and economics reporters to worry about strange and unlikely state of affairs with little consequence. But at a time when the economy is down almost 9 million jobs from its trend level, wages are going nowhere, and growth is not much above zero, worrying about the Fed losing money on its bond purchases is more than a bit bizarre. But apparently this is the concern that occupies the Los Angeles Times business section and apparently some members of Congress.

The basic idea is that if interest rates suddenly soar then the bonds held by the Fed will be worth less, so the Fed will take a loss on its bond holdings. If the losses are large enough and the Fed realizes its losses by selling its bonds, then it could actually be insolvent.

The idea that long-term bonds fall in value when interest rates rise is not exactly new. Some of us suggested taking advantage of this fact to get around the nutty debt cult that controls Washington these days.

But what would these mean for the Fed? First, we should ask under what circumstances would interest rates rise suddenly? Presumably this would be the result of a rapid recovery of the economy. If that happened, and we suddenly get back the 9 million jobs we lost, a shortfall at the Fed would be a pretty silly thing to worry about.

Alternatively, we get a sudden spike of interest rates because aliens dump their bonds in huge amounts, even though the economy is still weak. Guess what the Fed could do then? That's right, if the economy is still weak, it can buy up those bonds and keep interest rates low and bond prices high. Are you scared yet?

Alright, but one of these days the economy will recover and the Fed will want to take reserves out of the system to prevent inflation. If it felt it had to sell off its bonds quickly, and then take a loss, it could face insolvency.

There are two points on this one. First, this is pure and simply an accounting issue. Congress could change the law and allow the Fed to have a negative balance. The consequence for the government and the economy would be precisely zero. The other possibility, for those who find the first solution to be too simple, would be to have the Fed slow the economy by raising bank reserve requirements. This would accomplish the same result. It is also a simple and old-fashioned mechanism.

So put the insolvency of the Fed off the list of things to worry about in your lifetime. Unfortunately we do have real world problems to deal with.

Comments (10)Add Comment
good catch...this is as goofy as saying the fed has a balance sheet....
written by pete, October 29, 2013 5:54
The Fed's bonds are just held in receivership of sorts. The treasury pays interest to the fed, who then pays the interest back to the treasury, a kind of laundering. In my readings of monetary policy papers, the assumption was that the fed bought bonds and they disappeared, which is logically what occurs! Fed debt should not be counted as national debt. Further, the Fed has much more in gold than is reported. It is reported at like $40 an ounce instead of market to market.

Of more concern should be lenders who have 30 year mortgages at 4%. These will be horrible on the books if interest rates rise, a la the 1980 banking crisis.
Dean, raising reserve requirements would do very little to the economy
written by Auburn Parks, October 29, 2013 6:37
Banks are not reserve constrained under any circumstance under which the Fed was targeting interest rates. This is the exact definition of setting either the price or the quantity. If the Fed sets a 5% target and reserve requirements were 100%, Bank lending still wouldn't be reserve constrained. If the Fed didn't provide enough reserves to maintain its target rate as lending and thus reserve requirements increased, the shrinking number of available reserves would be bid up to infinity. Exactly the opposite of QE, the Fed has now effectively set the quantity greater than the demand, therefore rates revert to their natural position in a fiat monetary system = 0%. I've personally heard you sit in as moderator with Scott Fulwiler at Columbia, certainly you should understand this fundamental nature of buffer stocks by now.
...
written by Avante Guard, October 29, 2013 6:41
The Federal Reserve Banks are owned by their member banks. If one of the banks depleted its capital because a rise in interest rates, it could raise capital from its owners, perhaps by adjusting down the bank reserves (liabilities) and adjusting up by an equal amount the capital account (equity.) This might not make the banks happy but there are plenty of excess reserves so it would have no effect on monetary policy.
...
written by Last Mover, October 29, 2013 6:52

If you think this is a problem, just wait till the Fed starts buying up cap and trade pollution permits so no one can emit CO2 into the atmosphere ... then sells them all back for practically nothing after global warming is proved a hoax.

Headline: USA Federal Reserve bankruptcy from sale of cheap emission permits replaces global warming as number one crisis driving world towards destruction.
...
written by Avante Guard, October 29, 2013 6:55
I'd like to point out that the SOMA is entirely at the NY Fed. As of the latest report, securities held outright: total 3,566,226; NY Fed 1,977,618. A rise in interest rates would make the NY Fed become insolvent long before it affected any of the other reserve banks.

An increase in reserve requirements would affect all reserve banks equally, so it might not be the best tool for this problem.
The New Lower Standards for Working Folks - Tyler Cowan
written by James , October 30, 2013 2:04

http://finance.yahoo.com/blogs...7936.html

"As Cowen explains further in the video above, the United States is probably unlikely to return to the easy prosperity of the post-World War II era, which swelled the middle class and allowed millions of families to build wealth and save for retirement with little more than a strong back and a will to get ahead.

Cowen says it will be tougher to get ahead in the future, for three reasons familiar to anybody who’s been paying attention to the shifting fortunes of U.S. workers. First, companies are much more careful these days about taking on workers and committing to the cost of labor, benefits, and the problems sometimes caused by humans on the payroll. Second, globalization means there’s more international competition for jobs at all levels. Third, automation allows many companies to replace people with technology."

I regret reading this b4 bedtime.

Truly, BTP readers know this is not accidental.


Insolvency is bunk, and reserve balances are neither here nor there.
written by Amileoj, October 30, 2013 2:23
Taking reserves out of the system will not prevent inflation and raising reserve requirements will not slow the economy. As Auburn Parks points out up thread, the Fed "normally" targeted a positive interest rate via open market operations and let the quantity of reserves float. More recently it has flooded the banks with excess reserves and maintained a (very low) nominal rate by directly paying it as a support rate on those reserves. Either way, there is no causal link between quantity of reserves and any important macro outcome.

You are on firmer ground in pointing out that so-called Fed "insolvency" would be strictly an accounting matter, with zero economic impact.
...
written by skeptonomist, October 30, 2013 9:46
The alarmists may have overlooked a source of loss for the Fed (article is behind a pay barrier), which is the $1.4T in MBS's that the Fed holds. Many of these are worth little and the Fed probably has no plans to sell them ever, so will take a loss when they mature (or maybe has already written them off). But such losses are basically meaningless, except as they represent a subsidy to the issuers and former holders.
skepto on top as usual,,,,
written by pete, October 30, 2013 10:22
Lets mark the MBS to market and the gold to market, they probably net out. Regarding the MBS, they must have risen quite a bit lately with the housing "rebound". I suspect on a mark to market basis the Fed has scored big time on these, much as they have by inflating the price of gold.
MBS disentanglement
written by Squeezed Turnip, October 30, 2013 7:58
True, the MBS values must be improving (when the market gets back to trend, it should be a wash). But also the Fed could (did?) renegotiate terms on the instruments, peeling out the toxic stuff, so to speak.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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