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The Federal Reserve Is Out of Reserves

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The Federal Reserve Is Out of Reserves

Washington Examiner December 19, 2018
EconomicsMonetary Policy

The economy appears healthy. Economic growth is 3.5 percent, nearly reaching the 4 percent growth President Trump promised when campaigning. Unemployment is 3.7 percent. Yet one number points out the fragility of the others: $66.5 billion.

That’s how much the Federal Reserve, the U.S. central bank, reported recently in “unrealized losses” on its investment portfolio. These losses are the delayed bill for the Fed’s 2008 bailouts of the housing market — and a reminder that the economy is still dependent on extraordinary government support.

As Bloomberg and others have pointed out, the loss makes the Fed insolvent. The Fed has only $39.1 billion in capital. If the central bank, in charge of setting interest rates for the U.S. economy, were a normal bank, the loss would spur regulators, including the Fed, to take it over as a failed entity.

That is ironic, but not the problem: The Fed is not going anywhere.

The problem is how the Fed actually got to be insolvent. The Fed is not losing money on Treasury bonds and notes, which it has, since its creation in 1913, bought and sold to help set interest rates. (When the Fed buys Treasurys, interest rates go down; when it sells them, interest rates go up.)

In this market, the central bank is nearly breaking even, with “only” a $700 million loss, less than 1 percent of its $2.4 trillion in such holdings.

The cratering value is in other types of securities: bonds backed by residential mortgages guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, themselves government entities.

Before 2008, the Fed did not buy or sell these mortgage-related bonds. That was wise: In confining itself to Treasurys, the Fed didn’t favor any particular area of the private sector economy. It treated industries and companies equally.

In November 2008, though, the Fed changed nearly a century of policy. It plunged into the mortgage-bond market, accumulating $1.7 trillion in such bonds by 2010.

The reasoning was that it wasn’t enough for the Fed to push Treasury interest rates down to record lows and hope that mortgage interest rates followed them down. The Fed wanted to directly reduce mortgage rates, to keep people borrowing so that they could buy houses, to keep house prices up.

It’s these bonds that are now losing money — nearly 4 percent of their face value.

Was the Fed financially stupid in buying these bonds? No, it most likely knew, eventually, these assets would lose money.

That’s why few other investors wanted these bonds. The investment world was worried about the house values indirectly backing such bonds, as well as the bonds’ particular sensitivity, eventually, to higher interest rates. Though mortgage borrowers can lock in low rates for decades, their lenders (the private institutions that traditionally purchase these bonds) generally can’t.

One argument is that the Fed did a good thing in buying mortgage-related bonds when everyone else was selling them. The tactic blunted the effect of falling house prices by allowing people to continue to borrow and refinance at cheap rates.

The counterargument is that the Fed’s move has helped inflate another housing bubble. Home prices are once again at record highs, contributing to the buoyant consumer sentiment that’s powering high growth.

Another counterargument is that by interfering in one industry, the Fed will be tempted to interfere in others in a future crisis. Corporations, which had little debt in 2008, now have borrowed record amounts.

Would the Fed purchase trillions of dollars in corporate bonds someday to keep rates from rising too much here, and thus prevent distressed companies from laying people off?

The Fed’s debt losses are just on paper. But the economy is dependent on paper debt.

Nicole Gelinas (@nicolegelinas) is a contributing editor to the Manhattan Institute’s City Journal.