Politicians will rave over Fed losses, but don't be fooled

Politicians will rave over Fed losses, but don't be fooled
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Central banks are not profit-making institutions. In the 21st century, they are charged first and foremost with “maintaining price stability," i.e., keeping inflation low. They also have been given duties relating to financial stability and sometimes duties relating to regulation of banks and other financial institutions.

In good times, central banks make a profit. They usually hold a portfolio of bonds, mainly government bonds. Many hold the international reserves of their countries in the form of foreign government bonds.

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Many central banks make some kinds of loans to banks, earning them money. On the minus side, many central banks pay interest on bank reserve accounts, which are deposits of eligible banks with the central bank.

 

Since the financial crisis, however, central banks have supersized themselves, buying massive amounts of bonds.

The Federal Reserve’s large-scale asset purchases, popularly referred to as quantitative easing (QE), have turned the Fed from a merely large institution with assets of about $600 billion (slightly smaller than the very largest commercial banks) to a Hulk-like monster with over $4 trillion in assets (roughly 20 percent of U.S. GDP).

Central bank bond-buying was intended to reduce long-term interest rates, making it cheaper for businesses to get loans to finance investment and for households to get home mortgages. However, in making these purchases, central banks acquired a portfolio that naturally loses value when interest rates go up.

Central banks have had no desire to rapidly dump their bonds, since this would have pushed interest rates through the roof, choking off recovery. But, as the economy recovers and interest rates rise, these bonds, which bear very low interest rates, lose value. Newly released bonds with higher interest rates are more attractive.

If central banks are not about making a profit, how important is it that their assets stand to lose value?

At one level, it just is not important. Central banks bought those bonds to help revive economies stricken by the financial crisis and Great Recession. The fact that they are likely to lose money on these investments a few years later as interest rates rise does not in any way call into question the decision to buy the bonds in the first place.

But there are some issues and risks that matter not only to central bankers but to the rest of us as well. First, when central banks make a profit, they turn most of it over to the government.

The Federal Reserve, for example, has made handsome contributions to the federal budget since it began its “fat years.” Rising interest rates should reduce or even eliminate this profit.

Fed researchers wrote about this in a 2015 article. Their projections assumed that the Fed would raise the federal funds rate to 3.5 percent (it is only 1.5-1.75 percent now) and that the Fed would have substantially decreased its bond holdings by 2018.

In short, the researchers predicted much faster increases in interest rates and much more rapid decreases in the Fed balance sheet than the actual outcomes. Still, in most of their projections, the Fed was able to pay something to the federal government in every year.

That may not satisfy revenue-hungry members of Congress. Still, the Fed researchers did not have to discuss in detail the second problem that central bankers worry about. In an extreme case, a central bank could actually lose enough money to require more capital from its government.

This can be politically unpleasant indeed. Few politicians can resist the temptation to scold a central bank that loses money, even though making money is not at all the central bank’s purpose. Interests opposed to central bank independence can have a field day in this situation.

Less dramatically, central banks are often called on the carpet for achieving subpar returns on their portfolios or for drops in revenues. Even when central banks do choose which foreign bonds to buy, however, they cannot afford to take a lot of risk.

Central banks that manage a country’s foreign exchange reserves simply should not allow hard-earned dollars, euros or yen to evaporate in high-risk investments that seemed to promise high-yield. Central banks, when they do have a choice, invest much more like tortoises than hares.

What sort of a politician would want to take direct control of the central bank and all the headaches involved in monetary policy? Sadly, there are those who are just looking for an excuse to seize the wheel, and central bank losses can be a convenient excuse.

Something that should not matter much could become quite significant in the looking glass of politics.

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.