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Is borrowing short and lending long a risky strategy for the Fed?
The Federal Reserve today is holding $1.4 trillion in U.S. Treasury securities, which is $600 billion more than it held four years ago. The maturity of those securities has also increased significantly. In April 2007, more than half of those securities were one year or shorter. Today, the fraction is down to 8%. Percentage of Federal Reserve holdings of U.S. Treasury securities by maturity, April 2007 and April 2011. Data source: H41.
Since 2007, the Fed has also acquired $132 billion in debt from Fannie Mae, Freddie Mac and the Federal Home Loan Bank, and $937 billion in mortgage-backed securities guaranteed by Fannie, Freddie, or Ginnie Mae. Where did the Fed get the money to buy all this stuff?
The answer is, whenever somebody sold these items to the Fed, the Fed credited an account that the seller's bank maintains with the Fed in the form of new Federal Reserve deposits. At the moment, most of those new reserves are just sitting there at the end of each day on some bank's balance sheet. Reserve balances with Federal Reserve banks have gone from $9 billion in April 2007 to almost $1.5 trillion today.
The Fed is currently paying banks 0.25% interest on those reserves, and is collecting an average interest rate of 4% on its long-term securities. That netted the Fed a healthy profit of $80 billion in 2010, which it returned to the U.S. Treasury. In effect, the Fed is borrowing short and lending long, making a huge profit on the difference, and handing it back to the Treasury.
But of course, that only works in your favor when the short rate is below the long rate. At the moment, the short rate is well below the long rate, and historically that has been the average relation. But if short rates rise, is the Fed exposed to a loss on its portfolio?
A recent article by Glenn Rudebusch of the Federal Reserve Bank of San Francisco notes that the risk is substantially less than the simple "borrow short, lend long" interpretation might suggest. The reason is that $1 trillion of the Fed's liabilities take the form of currency in circulation, which you can think of as funds the Fed has permanently "borrowed" at 0% interest. Rudebusch calculates that the interest rate on reserves would have to rise to 7% in order for the Fed not to earn a positive cash flow on its current portfolio, once you factor in the benefit to the Fed from the fact that a good fraction of its liabilities require no interest payments.
Rudebusch's conclusion is that if the Fed's holdings of MBS and longer-term Treasuries are providing a beneficial economic stimulus, fears of interest rate risk to the Fed's portfolio are not a good reason to alter the course.
Posted by James Hamilton at April 13, 2011 11:28 AM
What about to the treasury?
Posted by: aaron at April 13, 2011 12:05 PM
The cash flow difference on interest rates is a red herring. They have a huge margin of safety there.
The real issue is mark-to-market losses on their long-duration assets if rates rise. And if the Fed responds that they don't have to mark to market because they will hold to maturity, isn't that an admission that they can't shrink their balance sheet if they need to?
Posted by: W.C. Varones at April 13, 2011 12:19 PM
The Fed has no risk. The trearsury, of course, does. With rates low, the treasury by borrowing short is risking a rate rise by an independent fed which will increase the financing costs. On the other hand, the long term bonds will look sweet with low rates and a huge inflationary increase in rates. If that is the plan the treasury should increase its duration.
Also a kind of incomplete distinction between currency and reserves, since I would bet that some of the reserves are actually currency at the Fed rather than line items on some ledger? And if so that currency still gets interest from the fed. Whether the currency has been printed or not, but not yet withdrawn by the bank, should not matter. The absolute obligation of the fed is to print the currency underlying the reserves. Thats why they are paying banks to keep them there.
Posted by: pete at April 13, 2011 12:20 PM
"Is borrowing short and lending long a risky strategy for the Fed?"
No, but please answer the question:
"Is the Fed's borrowing short and lending long a risky strategy for the Treasury?"
I'll buy this: "Rudebusch calculates that the interest rate on reserves would have to rise to 7% in order for the Fed not to earn a positive cash flow on its current portfolio"
So what would happen to the US federal budget deficit if new debt issues came in at 7%? Can the answer be anything not including the word disaster?
Posted by: KevinM at April 13, 2011 01:26 PM
OT
Platts on OPEC output
The latest batch of estimates of OPEC production, including OPEC's own, show that the cartel did not cover the drop in Libyan production in March.
The IEA shows Libyan production falling by 940,000 b/d month-on-month to 450,000 b/d and total OPEC output falling by 880,000 b/d. The EIA puts Libyan production at 300,000 b/d, 1.04 million b/d lower than February levels, and OPEC output at 28.72 million b/d, 1.27 million b/d down from February.
Platts' latest survey of OPEC and oil industry officials and analysts estimates that Libyan output dropped by 930,000 b/d to 460,000 b/d in March and that total OPEC output fell by 630,000 b/d to 29.17 million b/d.
OPEC itself, using secondary source estimates, puts March output at 29.12 million b/d, representing a drop of nearly 627,000 b/d from February, with Libyan production down nearly 990,000 b/d at 366,000 b/d.
Saudi Arabia's March output is pegged at 8.9 million b/d by the IEA, 8.961 million b/d by OPEC, 9 million b/d by Platts and 9.1 million b/d by the EIA.
All of which begs the question: What are the conditions Saudi Arabia and OPEC see as the justification for the sort of output increase that will at least cover the entire loss of Libyan production?
OPEC has insisted that the high prices currently prevailing on world oil markets--earlier this week, North Sea Brent traded at a new 32-month high of $127.02/barrel--have more to do with speculative activity than with fundamentals of supply and demand.
"In terms of fundamentals, the recent events alone do not justify the current high price levels. Instead, these represent a sharp increase in the risk premium, reflecting fears of a shortage in the market in the coming quarters," OPEC's Vienna secretariat says in its latest monthly report.
OPEC members, the report says, "have accommodated most of the shortfall in [Libyan] production, ensuring that the market is well supplied."
But if OPEC considered markets to be fairly balanced when Libyan supply was running at normal levels of close to 1.6 million b/d earlier this year, are they still balanced now that Libyan crude exports are virtually nil?
http://www.platts.com/weblog/oilblog/2011/04/13/should_opec_pum.html
I think this fairly expresses my sentiments on the matter.
Posted by: Steven Kopits at April 13, 2011 02:29 PM
So long as we don't have an aggressive energy policy, we set the stage for this kind of dynamic.
Posted by: aaron at April 13, 2011 03:07 PM
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