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JPMorgan Chase & Co
American International Group Inc
The Federal Reserve has become more profitable than ever since the outbreak of the financial crisis, clearing $77 billion last year. So it seems surly and peevish even to ask the question of whether it could suffer a loss. But it’s important to consider given the Fed’s importance to the economy, amid talk of another round of the monetary stimulus known as quantitative easing. Could the Fed lose money—and if it did, would it matter?
JPMorgan Chase (JPM) economist Michael Feroli takes these questions on today in a research note and concludes three things: The chance of a Fed operating loss is “extremely remote.” A loss would be “of little real consequence.” Nevertheless, “this remote prospect may make the Fed marginally less inclined to expand its balance sheet.”
Feroli right away dismisses the fear that the Fed will lose money on a lot of the iffy securities that it acquired during its rescue of the financial system—loans to commercial banks, American International Group (AIG), and various other debtors. “Those have almost all been wound down,” he writes.
One can also imagine the Fed’s portfolio of nearly $3 trillion in assets taking a big hit from rising interest rates. (Fixed-income securities lose value when rates rise.) But the Fed doesn’t carry those assets on its books at their current market value, so it doesn’t have to acknowledge the impact of a rate rise on its balance sheet unless it sells something.
OK, but could the Fed lose money if the interest it pays banks on their reserves starts exceeding the income the Fed earns on its portfolio of securities? The bigger the Fed’s balance sheet, the greater the risk of that happening. But Feroli notes that the Fed has the good fortune of paying zero on its biggest single liability—the cash that it issues. And as it shrinks its balance sheet, cash will be a growing portion of total liabilities in the future.
If for some reason the Fed did lose money, there would be no real economic effect but there could be a political blowback, Feroli says. “There is a risk that the headline ‘Fed Loses Money’ could lead to an embarrassing political situation.” Not wanting to put itself in that embarrassing position, the Fed might decide that a bigger balance sheet is too risky. If it’s a close call whether the economy needs another round of quantitative easing, this consideration might tilt the Fed against QE3, Feroli says. Given the fragility of the economic recovery, that’s cause for concern.
Bottom line: Although the chance of a loss is very small, even the possibility could color the central bank’s decision-making. And that could have enormous consequences for the U.S. economy.