Commentary: Fed Capital, Central Bank Solvency, and Budget Gimmickery

It's the last day of 2015,and the Fed transferred an additional 19 billion dollars to the US Treasury in accordance with a key funding provision of this year's Highway Bill.  Many commentators have called this move a "shakedown" or theft.  Some Fed officials, including Chair Yellen, are concerned that the move threatens the central bank's independence.  The latter may be closer to the truth.  In reality, this transfer has no economic significance whatsoever. 

Fed Profitability:

The Fed earns billions of dollars every year, most of which is remitted to the US Treasury.  The Fed creates money out of nothing and uses that money to purchase interest bearing securities.  Until recently, nearly all of the Fed's portfolio was US Treasury securities.  By purchasing these securities and earning interest on them the Fed is effectively saving the government interest costs.  By "paying" interest to Fed and having the money sent back to the Treasury, the US government is effectively borrowing money from the Fed for free.  Since the crisis, the Fed has also purchased bonds backed by mortgages. (Not subprime, but mostly conventional, 30 year fixed rate mortgages which performed very well during and since recession) Since the interest on these bonds is paid by homeowners, the earnings derived from these purchases can be thought of as a seigniorage tax.  As we shall see, the the exact nature of the transfer is not economically but politically significant.  While the expansion of the Fed's balance sheet was intended to jolt the economy by reducing long term borrowing rates, it had the side effect of raising nearly half a trillion dollars in revenue for the Treasury.  The fact that monetary policy can be profitable can spell trouble for central bank independence if the Federal Government were ever to pressure the Fed to put earnings ahead of economic stability.  

The Transfer: 

The 2015 Highway Bill orders the Fed to reduce the money in its Surplus Capital Account to 10 billion dollars, resulting in a 19 billion transfer to the Treasury. Crucially, the Fed will effectuate this transfer by selling securities it already holds in its existing portfolio.  This will reduce future Fed earnings and thus remittances to the Treasury.  Mechanically,  the Treasury will thus make interest and principal payments on these securities to private bond holders instead of the Fed. The net result is thus no different than if the Treasury itself had issued new bonds at one of its weekly auctions.  The only distinction is political, not economic. Since only bonds sold by the Treasury count against the official national debt under government accounting rules, Congress can make it appear as though the Highway Bill is deficit neutral.  

Fed Capital?: 

Budget games aside, the need for the Fed to hold capital is certainly a head scratcher that our own central bank seems to have acknowledged.  From a 2002 GAO report,  

Federal Reserve Board officals have noted that it can be argued that a central bank, including the Federal Reserve System, may not need to hold capital to absorb losses, mainly because a central bank can create additional domestic currency to meet any obligation denominated in that currency. 

The Fed also pointed out that its capital was largely symbolic.  From the same document as above, 

[Fed credibility...] could be fall if large losses wiped out the Federal Reserve's capital accounts, giving the misimpression that the Federal Reserve was insolvent. 

In other words, the unlike a commercial bank, Fed does not need to hold capital to maintain solvency or cover its losses because it liabilities all denominated solely in US dollars which it alone can print.  Alas, everything it not all hunkey dory.  Although in a technical sense the Fed can never face financial ruin or go bankrupt, it still faces constraints so long as it is committed to achieving its objective of price stability. 

Policy Insolvency: 

One danger is that of so called policy insolvency, where the Fed (or any central bank) remains solvent only by abandoning its policy objectives.  One scenario could include a rapid normalization of monetary.  If inflationary pressures picked up and the Fed wanted to accelerate the pace of interest rate hikes, it would be very difficult for the Fed to raise short term rates above the aggregate interest rate it earns on the securities in its portfolio.  Because the Fed is controlling interest rates by setting a price floor, it has committed to pay interest on the trillions of dollars of reserves it created to finance the expansion of its balance sheet.  With most of its security holdings yielding on average about 3 percent, the Fed could experience negative earnings if it set short term interest rates north of 300 basis points in the medium term. It could make up the difference by selling some of its securities, but it would realize losses because bond prices fall as interest rates rise. The Fed could also just pay interest by creating more reserves.  Unfortunately, both of these options both entail  a permanent increase in the monetary base.This may have implications for price stability. Additionally, the Fed could avoid this scenario by keeping the Federal Funds rate below the rate of interest it earns on its securities.  The Fed would be putting earnings ahead of price stability, essentially abandoning its objectives.   To avoid expanding the monetary base, the Fed could of course ask the Treasury for money to cover its shortfall.  However, the politics of such a move would be treacherous and currently the political will does not exist to enact such a program if it were necessary.     

All About that Base: 

However, the dangers described above rest the very shaky assumption that only the monetary policy variable is the size of the monetary base.  Followers of this extreme form of monetarism predicted (wrongly) that QE would result in hyperinflation.  What Ben Bernanke and many other economists understood perfectly well in 2008 and before was that the monetary base is not a constraint on bank lending and thus a poor forward indicator of inflation.  Crucially, because the Fed (and most other central banks) have explicit interest rate targets, they are committed to supplying such reserves as are necessary to meet that target.  Thus, central banks expand the monetary base to meet demand on a daily basis.  The real "printing press" is thus the banks themselves as they create credit and borrow reserves to fund new loans.  All about that base might be a catchy pop song, but it is an inadequate description of monetary policy or the process of money creation.      


Conclusion: 

In sum,  concerns about Fed solvency rest on faulty assumptions regarding the true constraints on bank lending and money creation.  Congress's latest move is more about political dysfunction than economics.  The real question is whether or not a sudden burst of inflation would find the Fed under political pressure to keep rates low in order to maintain positive earnings to both keep remittances high and thus avoid the need to fund expenditures with taxes or Treasury bond issuances. This lack of transparency is no way to run a country, let alone a superpower.  In the end, it's not at all reassuring that while the Fed will not have to choose between solvency and price stability, in Congress political gamemanship reigns supreme.   

 
 

Commentary: First Week Under the New Monetary Regime

It's the week of Christmas, but it's also the first week of a very new monetary framework in the United States.  When Federal Reserve hiked interest rates last week, it implemented it's policy change in a very unique manner.  Rather than selling Treasury securities into the market to drain liquidity out of the financial system, the Fed raised interest rates it pays on reserves. The Fed will pay 25 basis points to institutions which engage in reverse repurchase agreements (RRP) with the central bank, and 50 basis points on excess reserves. The idea is that the Fed is trying to set an effective price floor in the 25-50 basis point range.  The Fed is taking this new approach because the system is so awash in liquidity that it would need to unload trillions of securities in order to get short term interest rates up.  This would risk destabilizing the bond markets and send longer term interest rates soaring. 


In assessing the effectiveness of the Fed's new policy, it is critical examine the behavior of short term interest rates.  This will allow us to gauge the firmness of the Fed's newly constructed price floor.


Libor and Effective Fed Funds Rates have Fixed Higher:


Both libor for USD and the effective Fed funds rates have fixed around 36 basis points since the Fed moved.  However, it is dangerous to put to much stock in these figures, since again, given that the system is still full of liquidity from  QE, banks have no need to trade Federal Funds anymore.  Volumes on this market are therefore miniscule, and not reflective of actual overnight rates.


Overnight Repo Rates are also Higher:


According the DTCC Overnight Repo Index , repo rates for Treasurys and Agency MBS/debentures have go up in the past week to settled around 30 basis points.  Volumes on this market are much higher (about 150 billion daily), and thus a more accurate measure overnight rates.  Earlier this year, most repos were trading around 15 basis points. The Fed seems to have succeeded in getting this interest rate, which financial institutions actually borrow at, to rise slightly. 
Oddly, Short-Term Treasury Rates Haven't Budged:
The US Treasury auctioned off 4-week bills at a 19 basis point yield on Tuesday, a basis point lower than a week ago, and well below the Fed's 25 basis point RRP floor.  While traditionally the US government has been able to borrow below short term money market rates, this has long been assumed to be a reflection of the small amount of counter-party risk entailed in overnight lending.  Indeed, lending the fact that parking your money with Uncle Sam is safer than investing it in a money market mutual fund was all to evident seven years ago.  However, this time, the counter party for the new RRP is the Federal Reserve System, a branch of the US Government itself.  The only explanation can be that firms with money to invest cannot access the RRP and are thus forced to invest in short term Treasurys.  


In sum, the Fed has gotten money market rates up a bit, but holes exist in the rate corridor it has built.  A much, much cleaner solution would be for Congress to grant the Fed authority to pay interest on reserves to any and all takers (not just banks).  This would allow the Fed to set a unified, and single rate which would act as a much firmer price floor on the money markets than today's two tiered system.    

Commentary: An Easy Fix For Puerto Rico

Puerto Rico, a political subdivision of the United States, is mired in an economic crisis and the Federal government is doing nothing.  That's very odd, considering that the economic performance of the US mainland is among the strongest in the developed world.  But even stranger is the fact that the strongest, most technically capable nation on earth is simply sitting back while 3.5 million of its citizens face economic depression and stagnation.  The decisive actions of the Federal Reserve and the Administration to address the economic crisis in 2008 are to be lauded and praised.  They were the actions of the great power, and helped pave the way for the strongest recovery from the recession among the advanced economies.  Today, the President Obama must summon the political will to act again to ensure a prosperous economy for ALL US citizens living both on and off the mainland. 

The problems facing Puerto Rico are simultaneously simple and complex.  Today, Puerto Rico faces a debt burden roughly 72 billion dollars, about 70 percent of the island's GDP.  Some of that debt is municipal debt owed by the Commonwealth government.  A large chunk of it is debt owed by state owned utility companies.  On January 1st, Puerto Rico must make interest payments of 957 million dollars.  Governor Garcia Padilla has announced his intention to default on this payment because it is impossible to pay creditors and continue to provide essential services.  

What got Puerto Rico in trouble fundamentally comes down to the loss of economic competitiveness, misguided economic policy, and bad luck.  Puerto Rico lost a key tax advantage in 2006. (companies could book profits in Puerto Rico and send them to the mainland tax free) This was the ultimate death knell for the manufacturing sector.  The Island government then tried to heavily subsidize electricity and energy to convince manufacturing firms to stay.  Ultimately, however, these subsidies failed to prop up manufacturing because of the huge pool of cheap labor which was mobilized around the world by the forces of globalization.  In the end, these subsidies only further indebted the Island government and the public power company.  Finally, a bit of bad luck brought on crisis. The global recession killed the tourism sector, and the island has never recovered.  Per capital income is down nearly five thousand US dollars in PPP terms since 2006. 

Puerto Rico is currently barred from declaring bankruptcy, since it is an unincorporated territory.  This prevents the island from restructuring its debt in the courts.  Therefore, Puerto Rico is in the unenviable position of begging for mercy from its creditors or going hat in hand to international lenders like the IMF or World Bank.  This inevitability is beneath the dignity of the United States.  The strings attached from an IMF loan would essentially give a foreign entity significant leverage over a US territory.  It would also signal to the world that the United States lacks the political will to stand up for its own citizens. 

Fortunately, the United States is not caught in an economic straight jacket despite political dysfunction.  The Exchange Stabilization Fund, a special Treasury account that the President can use without the authorization of Congress, must be mobilized to aid Puerto Rico.  Presidents of both parties have used the ESF to stabilize the economy at home and abroad when Congress has failed to act.  President Clinton used to the ESF to lend 20 billion dollars to Mexico in 1994 after Congress refused to pass the Mexican Stabilization Act. (Mexico repaid the loans early with interest) President Bush tapped the ESF to guarantee the solvency of key money market mutual funds during the 2008 financial crisis.  

 Since it is unlikely that Puerto Rico can reach a timely deal with its creditors, the United States should offer the holders of Puerto Rico's debt the following deal.  The United States will pay 70 cents on the dollar to all of the island's bond holders.  Most of the bond holders would gladly except this offer, given it is highly uncertain when, how much, or if even investors will be paid without intervention from the Federal government.  Next, by imposing some losses, we can address the moral hazard problem.  However, by quickly resolving the question of the debt, Puerto Rico will gain the space to reform its economy and keep the government open.  This is essential, especially given the depressed state of the Puerto Rican economy.  

Finally, Puerto Rico would still owe money back to the US Treasury, again stopping the moral hazard issue and giving the island ownership over an economic reform package (ending fuel and electricity subsidies, modernization of infrastructure, and ending the "tax haven" culture and focusing on building up real economic advantages such as an educated workforce would be high on the agenda) which could be implemented in partnership with the Federal government.       

Puerto Ricans, like all Americans, deserve and equal shot, and equal shake, and chance at the American dream.  The Federal government has a duty to all of its citizens, not just those living on the mainland.  In sum, it's high time that the Federal government get its act together and underwrite a credible debt restructuring plan for the Commonwealth of Puerto Rico.