In concluding my brief series on this topic, I will address questions regarding potential Federal Reserve insolvency and the desirability of permanently practicing monetary policy under a “floor” system. Hopefully the answers put forth will shed light on areas of the debate that remain dark.
Q: The Federal Reserve has recently been turning over to the Treasury approximately $80 billion in profits each year, stemming from the yield spread between their assets and liabilities. As the Fed eventually raises interest rates on reserves (assuming the “permanent floor” system remains in place), that yield spread could turn negative, representing losses for the Fed. If the Fed’s capital is entirely drained, can it continue to pay interest on liabilities (e.g. reserves) or must it first be recapitalized? If the latter, does this require Congressional approval, Treasury action, or some other mechanism?
A: Before trying to put forth an answer, I should note that the present likelihood of this scenario becoming a reality is extremely small and would probably be preceded by much higher inflation (and interest rates). As several commenters noted, finding a direct answer to this question is extremely difficult. Courtesy of Dan Kervick:
Here is a 2002 General Accounting Office report that discusses some of these issues:
From the “Results in Brief” section at the beginning:
The Reserve Banks use their capital surplus accounts to act as a cushion to absorb losses. The Financial Accounting Manual for Federal Reserve Banks says that the primary purpose of the surplus account is to provide capital to supplement paid-in capital for use in the event of loss. Federal Reserve Board officials noted that the capital surplus account absorbs losses that a Reserve Bank may experience, for example, when its foreign currency holdings are revalued downward. Federal Reserve Board officials noted, however, that it could be argued that any central bank, including the Federal Reserve System, may not need to hold capital to absorb losses, mainly because a central bank can create additional domestic currency to meet any obligation denominated in that currency. On the other hand, it can also be argued that maintaining capital, including the surplus account, provides an assurance of a central bank’s strength and stability to investors and holders of its currency, including those abroad. The growth in the Reserve Banks’ capital surplus accounts can be attributed to growth in the size of the banking system together with the Federal Reserve Board’s policy of equating the amount in the surplus account with the amount in the paidin capital account. The level of the Federal Reserve capital surplus account is not based on any quantitative assessment of potential financial risk associated with the Federal Reserve System’s assets or liabilities. According to Federal Reserve officials, the current policy of setting levels of surplus through a formula reduces the potential for any misperception that the surplus is manipulated to serve some ulterior purpose. In response to our 1996 recommendation that the Federal Reserve Board review its policies regarding the capital surplus account, it conducted an internal study that did not lead to major changes in policy.Based on this paragraph and corresponding discussion, the best current answer is that negative equity would not prevent the Fed from pursuing its desired monetary policy since “a central bank can create additional domestic currency to meet any obligation denominated in that currency.” If the Fed truly desired to maintain a capital surplus, to signal “strength and stability to investors and holders of its currency,” than one option is raising service fees charged to banks. This action would represent a tightening of monetary policy, but that could be desirable at the time.
If that course is not pursued, the other plausible action appears to be a Congressionally approved capital transfer from the Treasury. Although this action could be contended by politicians that oppose the Fed, the reality is that failure to provide capital would not alter the Fed’s ability to act or remain independent. Furthermore, a contentious Congressional battle on this otherwise insignificant matter could undermine the Dollar’s status as a reserve currency (similar to the debt ceiling debates). Provided this view is reasonably accurate, there appears little reason to fear the Fed losing its capital or as some argue, becoming ‘insolvent’.
Q: If the Fed leaves the zero lower bound (ZLB), is there any good reason to keep reserves in chronic excess?
A: Yes. An “interest-on-reserves regime” or “permanent floor”, where reserves are kept in chronic excess, allows the Fed to exogenously determine the monetary base AND interest rate. Therefore, if the Fed wishes to exit the ZLB it must either sell treasuries and Agency-MBS until excess reserves are practically eliminated (reverse QE) or increase the interest rate on reserves (IOR) to set a floor for the interbank market (target rate).
Given the response of asset markets to QE, the former option poses the risk of asset market deflation and possible spillovers to the real economy. To clarify, these arguments suggest there are good reasons to keep reserves in chronic excess but does not imply the Fed should permanently adjust to a “floor” system.
The “platinum coin” has been shot down as a potential response to hitting the debt ceiling, but it has made a substantial impact in expanding debates about how our modern monetary system actually functions. One of these topics, the “permanent floor,” will likely remain a prominent topic of macroeconomic arguments for at least as long as the Fed operates monetary policy within that system. The fantastic recent discussion on this subject has vastly improved my understanding of the policy’s intricacies, but has not altered my initial impression about the future practice of monetary policy (emphasis added):
An “interest-on-reserves regime” appears likely to rule monetary policy for the foreseeable future.
Special thanks are owed to Tom Hickey (Mike Norman Economics) and Michael Sankowski (Monetary Realism) for posting links to this blog. For their contributions through comments, I would also like to thank Scott Fullwiler, JKH, RebelEconomist, Dan Kervick, Ashwin Parameswaran, wh10, Detroit Dan, K, JW Mason, jck and last, but not least, Mike Sax.