Fed Economist Says It Should Build Up Capital

Fed Economist Says It Should Build Up Capital

October 16, 2010, 6:20 PM ET

By Jon Hilsenrath and Mark Whitehouse

Fed Economist Says It Should Build Up Capital
A senior Federal Reserve economist says the Fed should be setting aside more of its immense profits as a safeguard against future potential losses.

“The Fed is earning and turning over to the Treasury an enormous amount,” James McAndews, co-head of research at the Federal Reserve Bank of New York, said during a panel discussion at the Boston Fed’s monetary policy conference. “There is a case that of these extraordinary earnings today, some portion of those could be set aside.”

The Fed’s holdings have expanded from about $900 billion before the financial crisis to more than $2.3 trillion today. For now, the Fed is raking in profits on those holdings, which consists largely of Treasury bonds and mortgage backed securities. It turns the bulk of its profits over to the U.S. Treasury.

Through Oct. 13, the Fed had handed $60 billion in profits to the Treasury, up from $27 billion during the same stretch last year, according to Louis Crandall, an economist with Wrightson ICAP LLC, a securities firm.

However the Fed could easily one day turn losses. Say, for instance, inflation starts rising and the Fed needs to sell some of its immense portfolio of bonds to push interest rates up in order to counter inflation. It could lose money on the bonds it sells. It also pays interest to banks for reserves that they keep with the Fed. If interest rates move higher, the Fed’s interest outlays on these reserve could rise too.

Some Fed officials say they aren’t worried about this – including Mr. McAndrew’s, boss, William Dudley, the New York Fed president. Big losses wouldn’t be the same catastrophe for the Fed that they are for commercial banks. That’s because unlike commercial banks, the Fed can print its own money. It doesn’t have to worry about running short of funds the way commercial banks do.

“It is true that the larger the size of the balance sheet, the more likely it is that the Fed would ultimately sell assets back into the market, potentially at prices that could result in losses,” Mr. Dudley said in a recent speech. “Although some fear that such losses could compromise the Federal Reserve’s independence, there is no reason why this should be the case, providing we stick closely to our mandate at all times.”

Still, some economists counter that the Fed could use a bigger buffer against potential losses, if for no other reason to avoid bad appearances in the future. Its total capital, at $57 billion, is just 1.1% of total assets. If it runs through all of its capital, that wouldn’t look very good for the central bank, even though it can print all of the money it wants.

Marvin Goodfriend, an economist at Carnegie Mellon’s Tepper School of Business, noted another complication at the Boston Fed panel. Say the Fed has to push up the interest rate it pays on bank reserves to fight inflation and at the same time it is running big losses because its older bonds don’t pay much interest. It could be in the unusual position of printing money to cover its costs at the same time that it is trying to tame inflation.

Mr.Goodfriend the Fed should get a capital transfer from the U.S. Treasury. Laurence Meyer, of Macroeconomic Advisers, shot back, “absolutely not.” Mr. McAndrews said retaining more of its present profits would be a “good risk management approach,” which would ensure it has a bigger buffer for a rainy day in the future.

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