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.