By Sean Vidolin, Rutgers University
Despite record low yields on US treasuries, the Federal Reserve may continue their reinvestment of expiring mortgage-backed assets into longer term securities- a process called “quantitative easing”. The motivation of this process is to induce lower longer-term Treasury yields in hopes of encouraging reductions in longer-term private sector borrowing costs, such as mortgage rates. With the Fed funds rate already near zero, this monetary policy mechanism is now the Federal Reserve’s primary tool used to stimulate growth in our stagnant economy. With unemployment still hovering close to ten percent and housing numbers less than stellar, fears of a double dip recession have forced the Fed to continue to take action
The benefits to a continued large scale asset purchase (LSAP) are obvious. The purchase of long term securities lowers the rates on long term treasuries, thus affecting corporate and household borrowing rates. Cheaper mortgages and rates on business loans helps stimulate the economy by promoting capital and household spending. However, it is unclear how much this actually helps when rates are already this low.
The disadvantages are a little less clear. The dual mandate of the Federal Reserve states that it is to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. While there is no mandate specifying that the Fed must be profitable, in order to remain independent it must be self-funding. The Fed never had a problem remaining profitable because its balance sheet included tons of interest collecting assets and very few liabilities on which it paid interest. However, in 2008, the Fed started paying interest on bank reserves (IOR). Coupled with the past couple years of asset purchases, the Fed now has over $1 trillion in interest paying liabilities. With an average coupon of 4% on its roughly $2 trillion of fixed rate assets, the Fed is pulling in about $80 billion in interest income. With IOR at 0.25% on $1 trillion of liabilities, the income far surpasses the interest expense of $2.5 billion.
The problems don’t start to arise until the Fed begins raising rates as the economy picks up steam. Using the current balance sheet, the Fed will continue to be profitable so long as IOR remains below 7%. That is obviously a far out occurrence, but one we cannot count out since we have seen rates that high in the past. If the Fed continues its asset purchases, however, we would effectively see this rate drop. By continuing its LSAP, the additional purchases would lower the average coupon rate on the Fed’s assets to 3.5%. 3.5% on $3 trillion of assets is $105 billion in interest income. 0.25% on $2 trillion of liabilities is a $5 billion interest expense. The Fed will continue to be profitable until they raise rates. A 5% IOR would essentially eliminate all of the Fed’s profits. The rate right before the crisis in 2007 was 5 1/4%. A continuation of quantitative easing thus puts an uncomfortably low ceiling on the Fed funds rate and a threat to its profitability and independence.
