This post answers four frequently asked questions on the Fed’s balance sheet. The answers to the first two questions will affirm that the Fed is executing QT exactly as promised, even if it may not appear that way. The apparent discrepancy is due to TIPS appreciation and details in MBS settlement mechanics. The answers to the second two questions will show how the Fed balance sheet behaves when the Fed has and negative net interest income or capital losses. The Fed has special accounting rules where losses appear as “deferred assets” that will be repaid out of future earnings.
Is the Fed buying more Treasuries?
The Fed’s Treasury portfolio continued to grow even after QE due to principal adjustments from TIPS. Treasury Inflation Protected Securities (“TIPS”) are a type of Treasury security whose principal is adjusted for inflation each month to protect the investor from inflation. For example, $100 principal invested in TIPS would be adjusted to $110 principal after a year of 10% inflation. The Fed’s $370b holdings of TIPs has been gradually adjusted higher due to elevated inflation. That growth in turn shows up as small but steady increases in its overall Treasury holdings.
Since QT, Fed Treasury holdings have been dropping at a monthly rate roughly equal to the QT cap of $30b a month. Recall, maturing principal is allowed to roll off each month up to the QT cap limit and any amount exceeding the cap is reinvested. Maturing Treasury securities are scheduled to be redeemed on either mid-month or month-end, which are the same periods newly issued Treasury securities are settled. This is intended to allow investors to easily roll over their maturing holdings into newly issued Treasuries. This schedule is also why Fed Treasury holdings decline discretely twice a month.
Why isn’t Fed MBS Declining?
The Fed’s MBS holdings are declining, even if it is obscured by the sawtooth pattern of its holdings. The sawtooth pattern arises from the repayment and settlement schedule of MBS, where MBS generally receive maturing principal on the 25th of the month and newly purchased MBS settle around mid-month. The spikes in Fed MBS holding arise from the settlement of newly purchased MBS, and the declines are due to maturing principal. MBS securities are amortizing, so each monthly cashflow contains some principal which the Fed will either reinvest or allow to roll-off.
The Fed’s policy of settling MBS purchases within a 3 month window further obscures portfolio declines. The Fed will delay taking delivery of purchased MBS if it judges that postponement would improve market functioning. Although QE ended months ago, the Fed continued to reinvest maturing principal and those purchases have yet to fully settle. The amount of purchases yet to settle has declined since the onset of QT and will decline further when the QT cap is raised in September. At that time MBS reinvestment purchases will likely end because the QT cap will be higher than expected maturing principal.
For those seeking more details into MBS QT, John Comiskey has a good post demonstrating MBS QT using security level data.
Can the Fed afford higher rates?
The Fed will soon have negative net interest income from its portfolio, but it won’t make a difference to policy. The Fed earns interest income from its holdings of Treasuries and Agency MBS, but pays interest expense on its deposits (reserves) and repo borrowings (RRP). The net earnings from this “carry trade” are remitted to Treasury and total over $1.1t since 2009. Like any other bank, the Fed’s asset portfolio is comprised of longed dated assets but its liabilities are shorter dated and reset with changes in the Fed’s policy rate. If the Fed hikes to 3.5% by year-end as expected, then the Fed’s interest expense will exceed its interest income.
Negative carry is handled by the Fed through a special form of accounting that allows monetary policy to continue uninterrupted. The Fed will continue to pay its interest expenses, but will finance it by creating a “deferred asset” out of thin air. The deferred asset is essentially an IOU the Fed writes against its future income. The Fed expects to eventually have positive net interest income again when it cuts rates during the next economic downturn. Those earnings will first go towards repaying the deferred asset before being remitted to the U.S. Treasury.
What if the Fed loses money on MBS sales?
Capital losses on the SOMA portfolio happen when the Fed sells an asset for less than its amortized cost. The market value of the Fed’s QE portfolio fluctuates with interest rates, but the fluctuations only matter if the Fed sells securities. Over the past ten years the Fed’s securities holdings have varied from unrealized gains of $400b to its more recent unrealized losses of $300b. The Fed does not mark to market and has held its securities to maturity so these fluctuations have not had any impact on its income statement or equity. However, potential future MBS sales may result in realized losses as MBS market values have recently declined from higher rates.
The Fed handles capital losses with the creation of a deferred asset. Private businesses may write down equity when they realize capital losses, but the Fed does not write down its equity. Instead, the realized losses will be recorded as a “deferred asset” and repaid with future net interest income. Realizing a loss may be politically troublesome, but it does not have any operational implications for monetary policy. At most it reduces future remittances to Treasury and so slightly increases the future budget deficit.