In a very interesting and provocative article last week, Greg Robb at MarketWatch reported on the Federal Reserve’s distribution of nearly $100 billion to the U.S. Treasury in 2014. Robb interviewed Marvin Goodfriend, a former economist with the Federal Reserve Bank of Richmond and now a professor at Carnegie Mellon University. Goodfriend made a case that the Fed should have considered waiting to distribute those earnings, given they are the product of monetary policy that can be likened to a “carry trade” in financial markets.
Put simply, a carry trade refers to positions where longer-term and/or riskier assets are funded with shorter-term liabilities with lower interest rates. Positions like these can easily produce “earnings,” for a while, but are subject to risk if the liabilities re-price at higher rates before the long positions are liquidated – and the long positions can fall in value at the same time funding rates begin to rise. That is why some people in finance sometimes derisively describe carry trades as “picking up pennies in front of a steamroller.”
This is a very interesting perspective for considering the Federal Reserve’s balance sheet, and its reported earnings. The Fed’s balance sheet expanded dramatically during and after the financial crisis of 2007-2009, as the Fed has driven short-term rates to near-zero levels while liquefying the nation’s banking system in its “quantitative easing” monetary policy. In the short run, this has produced significant boosts to the Fed’s reported profits, but the Fed is subject to risks on its assets if long rates rise.
In the MarketWatch interview, Goodfriend also pointed to the risk that the Fed’s cash flow could actually turn negative, possibly requiring a flow of funds from the Treasury to the Fed down the road, in the event of significant short-term interest rate increases. That kind of risk has Goodfriend concerned for the Fed, and Federal Reserve independence in monetary policy.
In a way, the Fed may be distributing “earnings” that have not really earned yet -- the carry trade has yet to unwind.
Meanwhile, just a note for now that the evolution in risk on the Fed’s balance sheet relates to another very interesting Federal Reserve accounting issue – how the Fed has historically accounted for the profitability of the (very large) payment services it provides to banks, under provisions in the Monetary Control Act that direct the Fed to price those services to “fully recover all direct and indirect costs.”