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WASHINGTON The Federal Reserve on Wednesday took another step in its effort to scale down a controversial bond buying program by an additional $10 billion.
January 29 -
Janet Yellen officially became Fed chair on Monday as former chairman Ben Bernanke announced his next steps.
February 3 -
The Federal Reserve Board denied the capital plans of Citigroup, HSBC, RBS Citizens, Santander and Zions in its second round of stress tests this year.
March 26 -
The Federal Reserve Board revised its findings to the closely watched Dodd-Frank Act stress tests on Friday, citing inconsistencies in the treatment of some figures during its calculations.
March 21
If the Federal Reserve were a commercial bank it would probably flunk its own stress tests.
Think about it. Under its aggressive quantitative easing program, the Fed is borrowing short-term and investing long-term, exposing itself to severe interest rate risk when short-term rates rise. If a top-30 bank had that kind of risk on its balance sheet, it would be taken to task by examiners and shunned by investors.
Generally speaking quantitative easing can be defined as the Fed buying financial securities, not with the intent of lowering short-term interest rates as traditional monetary policy aims, but to increase the Fed's asset holdings and lower longer-term interest rates. The thought is that with longer term rates lower and security prices higher, individuals and businesses will be more willing to borrow, and more likely to buy things and invest. Think of it as monetary policy on stimulants.
How the Fed pays for these new longer-term asset purchases has changed relative to earlier monetary policy actions, as well. Prior to the financial crisis, the Fed would simply create reserves that they used to pay for their financial purchases. Banks would be happy to take these reserves to help them support new deposits that they could create when they made new loans. However, beginning in December 2008, the Fed implemented a new policy of paying 0.25% interest, or 25 basis points, on all reserves. Thus, it is more accurate to say that under the quantitative easing program in place the Fed buys reserves to pay for its longer-term security purchases. As such, it is operating like any other bank today, buying funds from one part of the economy and lending them to another.
This strategy has been highly profitable for the Fed. By earning close to 3% on its longer-term funds and paying only 0.25% on the liabilities used to fund these purchases, the Fed was able to return to the U.S. Treasury nearly $90 billion last year, over and above its expenses.
However, students of U.S. financial history are reminded of the savings and loan crisis in the late 1980s, caused to a great extent by these financial intermediaries engaged in very similar maturity intermediation. They borrowed short-term, three- to six-month money, to fund 30-year fixed-rate mortgages. As with the Fed today, this strategy was initially profitable. However, when interest rates began to rise, the losses quickly piled up. The Fed today is exposing itself to similar financial losses should interest rates rise.
Now some might be reassured by the recent guidance by the Fed that short-term interest rates will remain low for the foreseeable future. However, when I look back I don't see the Fed has done a great job of forecasting macro-economic events. For example, following the financial crisis, short-term interest rates fell much more than expected and have stayed low much longer than expected. The markets and the Fed were wrong in their earlier forecasts, and they could be wrong again. An end to the ill-advised quantitative easing program can't come soon enough.
Scott E. Hein is the Robert C. Brown Chair in Finance, Texas Tech University, faculty director at the Texas Tech School of Banking and former senior economist at the Federal Reserve Bank of St. Louis.
