Saturday, January 19, 2013

The Permanent Floor and Potential Federal Reserve 'Insolvency'

After furthering understanding of the permanent floor, I discussed how that monetary regime might affect the inflationary effects of the “platinum coin.” Although the debate appears to be dying down, at least momentarily, Simon Wren-Lewis and Frances Coppola (see here, here, and here) have added worthwhile readings.

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.


  1. I agree, Joshua. Interest-on-reserves is here for the foreseeable future. The discussion about how to return to "normal" is not the right one at this stage. The new "normal" is IOR. We have to learn how to live with it. The debate has quietened down over the weekend but I don't think we've seen the last of it yet by any means.

    There have already been extensive discussions about central bank insolvency in Europe, because the Target2 imbalances would potentially result in ECB insolvency in the event of a country leaving the Eurozone. The consensus seems to be that technical insolvency of a central bank would make no operational difference provided that banks and investors remained convinced that the government stood behind it and would actually recapitalise it if necessary. I like the term "negative equity" better than insolvency - it better reflects the true situation. Though some people are nervous about having a zombie central bank!

    Thanks for the links, by the way.

    1. Apologies for the delayed response, I was away visiting the future in-laws this past weekend.

      Even if we're wrong about the future of Fed policy, it will be several years before the Fed's balance sheet is reduced to a size by which it can target interest rates through the old method. That is assuming required reserve ratios are not increased for some odd reason. Either way, it will be imperative that the current monetary regime be understood, hence debates will continue.

      As for Fed "insolvency", I agree that "negative equity is a better term but recognize that many people believe the former is true. My feeling is that people are partially nervous about a "zombie central bank" because it further blurs the line between fiscal and monetary policy. Whether or not that is a legitimate fear doesn't prevent the perception as such.

      Regarding the ECB, I tend to have a slightly different view due to the numerous governments potentially required for its backing. In the US it seems fairly obvious the Treasury would support the Fed. However, if one or multiple countries choose to leave the Eurozone, a question then arises as to which governments may be left in the long-run. While the actual write-offs of Target 2 imbalances may not pose any real issues, I think it undermines the European financial structure far more so. Obviously I would be happy to hear your opinion and learn that those fears are misplaced.

  2. " 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."

    As the MMT economists would say, it is a policy choice and the choice is between running the bank for public purpose (first option above) or running for special interests (second option above).

    Monetary policy through setting the interest rate is a similar policy choice, and the current policy, based on (erroneous) NAIRU, uses unemployment as a tool to target the rate of change in the price level.

    This favors creditors at the expense of business in that is makes investment more expensive by increasing the cost of capital and creates idle resources in the economy by inducing economic contraction through wage pressure that reduces effective demand.

    A "politically independent" cb sitting at the top of the economy and using policy fof micro-managemnet creates a command system in the hands of a small group of unelected and unaccountable technocrats, which seems both anti-democratic and anti-free market. WTF?

    1. I can't argue with any of that. I've nearly completed Michael Hudson's, The Bubble and Beyond, which certainly makes a strong case about how the current monetary system favors a group of rentiers, similar to feudalism. Although we may differ on the government's role in our preferred systems, there is little question in my mind that the current system will continue perpetuating growing wealth/income inequality through asset bubbles and financial crises. Hopefully debates such as this one will expose many neoliberal myths about the monetary system and choices we face.

  3. This whole discussion make me thing the nature of central banking is like they person who tells a lie then has to tell another lie to cover up the original lie and so on. Does anyone know what they are doing?

    1. My guess is that there are many within the central banking who understand the nuances of our current monetary system but are pressured into publicly promoting other policies due to various incentives and political pressures.

    2. Yes I think your probably correct. It just makes me smile that the likes of Krugman and various other luminaries go all guns blazing to get the trillion dollar coin idea enacted then spend the two weeks following its demise clearly demonstrating across the Blogosphere they didn't really understand its ramifications! I'm beginning to think that high profile economists with a media pulpit should tag all their policy proposal with "Oh and BTW this will likely effect hundreds of millions of people in ways I don't yet know.."

    3. I frequently feel the same way. If you watch any financial television that dynamic becomes patently obvious. The most frequent guests are perpetually confident in their forecasts and policy proposals no matter how often reality proves them wrong.

      Maybe the blogosphere (internet generally) will alter this pattern in time. In that sense I remain cautiously optimistic.

  4. The implication of your piece is that inflation risk is exogenous to Fed policy. In other words, negative real rates can persist without influencing inflation. They are "equilibrium".

    In reality, negative term real rates are a huge anomaly: it is not clear why 10yr Treasury HTM holders sign up to lose real wealth, nor is it likely sustainable. One can argue about the explanation, but I think agency effects and bond price momentum have a lot to do with it.

    A more normal dynamic is for holders to flee a losing real HTM bet into inflation hedges. The desire to protect a portfolio against real wealth erosion causes inflation, not results from it. Faced with such a dynamic, the Fed would suffer a $300-500b loss (depending on balance sheet size) for every 100bp nominal increase in rates - much more for a real increase. That MTM loss is essentially a transfer of nominal wealth from the Fed to the private sector. On a "cash" basis, the reserves the Fed would issue to pay the IOR in that scenario would be different than the QE "swap". They would represent a direct net, nominal payment from the Fed to the private sector. In other words, this would constitute "helicopter money".

    Saying the "risk is low", is the same as saying, "its natural that 10yr bondholders will sign up to lose real purchasing power and not seek inflation hedges instead." But why would anyone retiring in 10yrs want to buy a 10yr Treasury today? The response is usually, "they are paying for safety". No, a term Treasury is not "safe": it has potentially catastrophic duration risk, for which a buyer is ahistorically paying for (rather than being paid to hold)!

    1. With regards to inflation, I would argue that both the Fed and Treasury have the ability to offset the other's inflationary effects. Negative real rates on Treasuries could persist while influencing the price level but inflation need not result if fiscal policy remains tight.

      A quick chart view in FRED ( shows that negative term real rates occurred within the US during the '50s, '70s, and '80s (data started in 1953). If one were to consider countries with a fiat currency, my guess is that negative term real rates are not as much of an anomaly as you suggest. Furthermore, it is in no way certain that 10yr Treasury HTM holders will lose real wealth, just as one cannot promise real gains for any other asset class.

      Even if HTM holders were to transfer into inflation hedges, the Fed could easily maintain current nominal rates by adjusting/expanding its own balance sheet. If instead they raised rates, I agree that future Fed losses would be equivalent to a transfer of nominal wealth from the public to private sector. However, I should note that current Fed profits stemming from several rounds of QE represents a direct, net nominal payment from the private sector to the Fed/Treasury (i.e. reverse "helicopter money"). Assuming we're on the same page still, do you agree that QE is disinflationary for the economy?

      Lastly, the risk is low partially because the Fed does not use MTM accounting. Unless the Fed elects to drastically reduce its balance sheet after raising rates, it should experience minimal nominal losses on current holdings. Although the yield on those holdings is low, it would likely require the Fed to pay IOR of at least 4-5% before witnessing significant nominal losses. I doubt we see short-term rates anywhere near that high in the next several years.

    2. Joshua,
      The outlier is negative real rates AND stable inflation. I'm less familiar with the Twist episode that drove real rates negative in the 50's. During the 70's, negative real rates were associated with accelerating inflation, as was the case in Latin America up until 1994 or so.

      If a rush into inflation hedges drove up inflation and the Fed held nominal rates down, this would make real rates more negative, causing more inflow to inflation hedges, etc. This is a feedback loop, not a stable equilibrium.

      QE is a swap of like assets: the direct effect on inflation is zero (people claim lots of indirect effects such as portfolio balances, etc). Seigniorage is not an asset swap: it is a nominal transfer from the pvt. sector to the fiscal agent. When seiniorage exists (i.e. when Fed's balance sheet is composed of currency primarily), an increase in rates is contractionary. When the balance sheet is primarily reserves, reverse seigniorage (Fed losses) is helicopter money. The more the Fed's balance sheet grows, the bigger the potential helicopter effect.

      "I doubt we see short term rates anywhere near that high." This implies a negative real rate is a stable equilibrium and not the source of a feedback loop. A "neutral" real rate of 2% would imply an IOR of around 4% today. If inflation rises to 4%, the number would likely be 8% (4% real required to arrest inflation).

      If you assume away inflation, of course, none of the above matters.

    3. When you mention "inflation hedges," what types of assets are you referring to? If you are referring to financial assets and real estate, than the increasing prices will not drive up inflation (as generally measured). In fact, the diversion of money towards financial assets (away from goods and services) will help to suppress general inflation. I agree this is not a stable equilibrium. However, the more likely result IMO is a crash in financial assets, not a major rise in inflation.

      "When the balance sheet is primarily reserves, reverse seigniorage (Fed losses) is helicopter money. The more the Fed's balance sheet grows, the bigger the potential helicopter effect."

      Completely agree. Just to make sure we're on the same page...seigniorage (Fed profits) are reverse helicopter money (contractionary). As Fed profits grow, the current helicopter effect is decidedly negative (reversed). Do you agree?

      "This implies a negative real rate is a stable equilibrium and not the source of a feedback loop."

      You appear to imply that the only way negative real rates could be relieved is through higher nominal interest rates (adjusting to current/higher inflation). What if the negative real rates are resolved through a decline in the inflation rate towards zero? Separately, why should the "neutral" real rate be 2%? Japan's real rate has fluctuated around one percent for the better part of two decades without leading to any inflation.

    4. Joshua,
      All good questions, especially the inflation hedge one.

      The character of inflation hedging (+/-) has to do with duration. In an economy where inflation is expected to be volatile, agents shorten desired duration. As a result, the main inflation hedge becomes pull-forward buying of inventory, short-duration FX, and perhaps precious metals (which arguably no nominal duration exposure). For instance, high/variable inflation countries tend to have no term debt issuance, regardless of the term premium. Further, high/variable inflation countries generally exhibit single-digit P/E ratios. Look at it from the standpoint of a business: if you don't know what your margin will be like in 5 yrs, will you invest in a long term asset or hold more inventory?

      On Fed profits, yes, they have been high. If I started a bank today with $40b in capital and put on a $2.5tr carry trade, my profits would look fantastic, and say little about potential losses.

      One of my main questions is, what would our unemployment, budget deficit, credit spreads, etc look like if we had a positive 1% real rate? The answer is we could not normalize to even Japan's level without causing discontinuities in each of those variables. Such is the fragility created by Fed policy.

    5. Diego,
      Given the outline for inflation hedging that you provide (which sounds reasonable), I would expect investors to reach for duration in this environment. The Fed's "success" in inflation targeting (ignore what that says for the economy/NGDP) and recent actions/goals would suggest a slightly higher rate of inflation that still has low volatility. With the Fed actively reducing the current supply of long-term assets, I would expect all other duration assets to be bid along with higher P/E ratios. Correct me if I'm wrong, but that sounds like a good description of the current environment.

      On Fed profits, I think we're on the same page at this point.

      In terms of your question, perhaps I see your initial point about the being unable to sustain negative real rates. I suspect you are correct that adjusting to a 1% real rate at this point would cause large swings in other markets. (Note: This assumes nominal variables can affect real variables, something market monetarists typically deny.) In time I think the affect of changes to the real rate may be a bit muted, but I do accept that Fed policy is making markets more fragile.

  5. The IMF's Peter Stella is very good on central bank capital. Start with "Do Central Banks Need Capital?". Alain Ize is good too.

    1. I think I've read some of Stella's work previously, but not sure which pieces at the moment. Anyways, thank you for the recommendations!

  6. "If that course is not pursued, the other plausible action appears to be a Congressionally approved capital transfer from the Treasury. "

    How would this work? What would be the transaction in t-account form?

    1. Not quite sure. Maybe the Treasury would deposit currency at the Fed in return for reserves? The transaction could also conceivably be a loan from the Treasury to the Fed? I'll have to do some research.

      PS - Just back from vacation. I'll respond to your email shortly.