Payment Due

The Fed had to take the punchbowl away from itself.

Losses from the Fed’s Quantitative Easing programme are eye-watering and will get a lot worse. Does it matter? The loss of profit transfer to the federal government will matter a lot. And that loss will be long-lived. QE was always an agreement to ‘Buy Now, Pay Later’. It is no good complaining about this agreement just because it has become time to pay.

QE was a maturity transformation on consolidated federal debt. The policy shifted overall government debt portfolio (government plus central bank) from long-duration to short-duration funding. That removed duration risk from the non-government sector, and added duration risk to the (consolidated) government’s balance sheet. There may be claims that Congress didn’t realise the fiscal risks embedded in the policy. But then no-one anticipated a need for much higher interest rates to counter inflation. Congress has sufficient financially literate members to realise that QE radically altered the interest rate risk embedded in the consolidated government balance sheet. 

The loss on QE is accruing currently at approximately US$ 8 billion per month, with no end in sight as long as rates stay high, as the following chart shows. Of course, the chart also shows how much the federal government benefitted from QE from 2008-2022. The official series is here.

Source: Federal Reserve

There are two main complaints about the losses.

1. That, properly accounted, they undermine the Fed’s capital base.

2. That the loss reduces the transfer of profits to the federal government.

We can just forget the first complaint. This blog is called Exorbitant Privilege and the loss is a prima facia example of a call being made on that privilege. The Fed long ago decided any losses on QE would be accounted as a ‘deferred asset’, gradually amortised by seigniorage. The ‘deferred asset’ is a drawdown by the Fed of its own future income, which is in huge demand. Hell, the Fed could probably securitise the loan and sell it if they wanted to reduce it. It would be unassailably AAA rated.

So, don’t worry about the Fed’s capital base - confidence will remain for a long, long time.

The fiscal transfer implications, on the other hand, are huge. The federal government is going to miss the profit transfers to the tune of hundreds of billions of dollars from the Fed for many years.

A good part of the loss forms a benefit that accrues to the banking system (or money-market funds in the case of reverse repurchase facility). This gain is especially pronounced with an inverted yield curve. The Fed pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings. The losses will now be paid by taxpayers.

Some suggest that removing or reducing the payment of interest on excess reserves and reverse repurchase facility will reduce the loss and avoid paying billions of unwarranted profit to the banking sector (and money market funds).

That’s a very difficult argument to sustain. The Fed HAS to pay interest on reserves and repo because the excess liquidity is so huge. Any meaningful reduction in those payments risks short term interest rates collapsing below the Fed’s target level. The FOMC have consistently said they wish to maintain high interest rates to address the inflation episode, so reducing payments on reserves/repo would risk undermining that policy.

So, at heart the Fed and the Federal government are just going to have to grimace and pay the QE bill for as long as inflation remains a problem. The best course of action is to batter inflation to death as soon as possible and shorten the period of QE losses. The Fed has to take the punchbowl away from itself.