economy

Aggressive rate increase path could threaten Fed profits, report warns

Aggressive rate increase path could threaten Fed profits, report warns

Derby’s Take: Aggressive Rate Increase Path Could Threaten Fed Profits, Report Warns BY MICHAEL S. DERBY | UPDATED JAN 05, 2022 05:30 AM EST Staying profitable could prove challenging for the central bank amid surge in inflation A top economist at J.P. Morgan says keeping the Federal Reserve’s books in the black could motivate the central bank to start an earlier and faster runoff of its balance sheet. Michael Feroli in a note to J.P. Morgan clients on Tuesday wrote that the status of Fed profits is politically fraught, because of the money the central bank makes for the federal government. As a self-funded government agency, the Fed collects interest on bonds it owns—it buys securities with money it creates out of thin air—and charges fees for services for banks. And after the Fed covers its expenses, it turns over the excess to the Treasury Department. As things stand, the Fed has been a very profitable institution. In 2020, the Fed handed back $87 billion, a 58% increase over what it sent the Treasury in 2019. But staying profitable could prove challenging amid an inflation surge that could force an aggressive path of short-term interest rate increases. According to Mr. Feroli, the point at which the Fed would start to lose money is nearer than one might think. If the federal-funds rate were to climb to 2.25% from the current near zero fed-funds rate target range, the Fed’s profits would dry up and it would be pushed into the red, he noted. For comparison, the Fed has penciled in a 2.1% funds rate by the end of 2024 and still maintains its longer-run rate will stand at 2.5%. “This shouldn’t create operational problems for the conduct of monetary policy, Mr. Feroli wrote, adding that “Fed officials have repeatedly stated that their objectives are the macroeconomic responsibilities given to them by Congress, not maximization of the central bank’s income. But at the margin “related headlines would be a little embarrassing and Fed leaders would likely face heat from Congress over losses Mr. Feroli noted. Raising interest rates would cost the Fed money because the central bank pays eligible financial institutions to park money with it. When the funds rate target goes up, the Fed has to pay more to bring in cash and tighten financial conditions. The Fed doesn’t explicitly need to generate profits and has ways to deal with technical losses so bankruptcy isn’t an issue, but the central bank is aware it would be politically challenging to find itself losing money. How does the Fed dodge this bullet? By accelerating efforts to shrink its balance sheet, Mr. Feroli wrote. The Fed’s holdings are now at about $8.8 trillion, having swelled because of its Treasury and mortgage bond buying since the start of the coronavirus pandemic in March 2020, when the holdings were $4.2 trillion—at the time a historically high level. Faced with a surge in inflation proving bigger and longer lasting than Fed officials expected, the central bank has moved forward the timing of interest rate increases and is now eyeing three for this year, compared with a single move forecast in September. One reason why the Fed has sped up winding down its asset-buying program is to give itself more space to raise rates, which it doesn’t want to do while its so-called taper of the program is in under way. Top Fed officials haven’t provided guidance about when a rate lift off might start, but Governor Christopher Wallersaid last month it could happen as soon as the Federal Open Market Committee meeting in March. Once the Fed finishes its taper it will need to decide whether to hold its holdings steady or let them run off. Mr. Feroli wrote that allowing holdings to shrink after a second rate rise seems likely, because that would take pressure off Fed profits that would be generated by the current mechanics for lifting rates. And there is an extra benefit, Mr. Feroli noted. A shrinking Fed balance sheet is widely viewed as a form of monetary policy tightening, so trimming it could help keep plans for rate rises on hold, in turn reducing the risk of central bank operational losses, he wrote. Download.

economy 2022-01-05 Livemint