Keywords: Federal Reserve's balance sheet, unconventional monetary policy, monetary policy implementation
Over the past few years, the Federal Reserve's use of unconventional monetary policy tools has led it to hold a large portfolio of securities. The asset purchases are intended to put downward pressure on longer-term interest rates, but also affect the Federal Reserve's balance sheet and income. We begin with a primer on the Federal Reserve's balance sheet and income statement. Then, we present a framework for projecting Federal Reserve assets and liabilities and income through time.
The projections are based on public economic forecasts and announced Federal Open Market Committee policy principles. The projections imply that for the next several years, the Federal Reserve's balance sheet remains large by historical standards, and earnings remain high. Using the FOMC's stated exit strategy principles and the Blue Chip financial forecasts of the federal funds rate, the projections have the Federal Reserve's portfolio beginning to contract in 2015. The portfolio returns to a more normal size in early 2018 or 2019, and returns to a more normal composition a year thereafter. The projections imply that Federal Reserve remittances to the Treasury will likely decline for a time, and in some cases fall to zero. Once the portfolio is normalized, however, earnings are projected to return to their long-run trend. On net over the entire period of unconventional monetary policy actions, cumulative earnings are higher than what they likely would have been without the Federal Reserve asset purchase programs.
To illustrate the interest rate sensitivity of the portfolio and earnings, we consider scenarios where interest rates are 100 basis points higher or 100 basis points lower than in the baseline projections. With higher interest rates, earnings tend to fall a bit more and remittances to the Treasury stop for a longer period than in our baseline projections, while with lower interest rates earnings are a bit larger and remittances continue throughout the projection period. With either interest rate path, earnings follow the same general contour as in the baseline analysis.
In response to the financial crisis that began in 2007 and the subsequent recession, the Federal Reserve has been employing a variety of nontraditional monetary policy tools. The use of these tools has significantly affected the size and composition of the Federal Reserve's balance sheet, as well as its earnings.3 The Federal Reserve's actions have garnered public attention, and Federal Open Market Committee (FOMC) members have often discussed in speeches and public forums how their actions have influenced the size of the balance sheet. The expansion of the balance sheet has also prompted questions about the interest rate risk of the portfolio. Using publically available data and Federal Reserve Bank accounting conventions, we project the Federal Reserve's balance sheet and income through 2025. The projections include alternate scenarios for monetary policy in 2013 and a rough gauge of the interest rate risk of the Federal Reserve's balance sheet.
As shown in Figure 1, through 2007, the largest asset item of the Federal Reserve (reported above the horizontal axis) was Treasury securities. The largest liability item (reported below the horizontal axis) was Federal Reserve notes - that is, currency. Prior to the financial crisis, the Federal Reserve's balance sheet grew at a fairly moderate pace, with the Open Market Desk (Desk) at the Federal Reserve Bank of New York purchasing additional Treasury securities roughly on pace with the expansion of currency and Federal Reserve Bank capital.
At the start of the financial crisis, the Federal Reserve's balance sheet began to expand at a faster pace, largely because of an increase of lending through the liquidity and credit facilities that were established at that time.4 These extensions of credit expanded the asset side of the balance sheet, while a substantial portion of the matching increase on the liability side of the balance sheet was in reserve balances.5 These liquidity facilities began to wind down as the Federal Reserve's asset purchase programs started to ramp up. As a consequence of the asset programs, the Federal Reserve's System Open Market Account (SOMA) portfolio-that is, its holdings of securities--more than tripled from 2008 to today, and in December 2012 exceeded $2.6 trillion.
Associated with the substantial change in the Federal Reserve's balance sheet has been a notable change in the Federal Reserve's net earnings. The Federal Reserve generates a substantial portion of its income from the interest-earning assets held by the Federal Reserve Banks, particularly in the SOMA portfolio. Federal Reserve expenses include operating expenses necessary to carry out its responsibilities, as well as interest expense related to certain liabilities of the Federal Reserve Banks; currently, the largest interest expense stems from reserve balances. Federal Reserve income, less expenses, plus profit and loss on sales of securities, is referred to as "net income." The FOMC pursues its statutorily mandated goals of full employment and stable prices, and the resulting net income is simply a by-product of the actions taken. The Federal Reserve is statutorily required to pay dividends on capital paid in. Under Board of Governors policy, after retaining sufficient earnings to equate surplus capital to capital paid-in, the Federal Reserve Banks remit residual net income to the U.S. Treasury.
As a result of the FOMC's actions to achieve its monetary policy goals, the Federal Reserve recently has been remitting more income to the Treasury than was historically the case. As shown in Figure 2, interest income has increased notably, particularly the portion attributable to the SOMA holdings of agency MBS. Moreover, interest income has risen significantly more than interest expense and, as a result, remittances to the Treasury have grown substantially in recent years, from roughly $25 billion per year, on average, from 2001 to 2007, to almost $80 billion in 2010 and 2011, and to nearly $90 billion in 2012, as shown in Figure 3. And, although some attention has been focused on the change in the balance sheet and the potential interest rate risk that the Federal Reserve has incurred, in fact, the Federal Reserve's securities portfolio currently has an unrealized gain position of roughly $249 billion as of September 2012.6
This paper describes a framework for constructing projections of the Federal Reserve's balance sheet and income statement under a variety of possible scenarios. These projections are not forecasts. As will become clear, the projections depend critically on a whole host of assumptions about future monetary policy decisions, financial market developments, and other issues. The assumptions and projections of each of those factors imply a path for the balance sheet and remittances to the Treasury. These projections illustrate how the various factors that affect the balance sheet and income of the Federal Reserve do so dynamically. Of course, other assumptions are plausible, and the aim of this paper is to illustrate how one could take various assumptions to create projections.
We base our modeling on three key inputs. First, we start with the Federal Reserve's balance sheet as of October 31, 2012 and model asset programs announced through December 2012. In particular, the FOMC's December 2012 statement indicated that:
"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month. [...] The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability."
The program outlined in this statement is highly conditional on macroeconomic outcomes. Modeling the joint macroeconomic and monetary policy interactions is outside the scope of the present paper. However, we consider the balance sheet and income effects of three alternative additional asset purchase amounts: no additional purchases; $500 billion in additional purchases in 2013 at a pace of $45 billion per month of Treasury securities and $40 billion per month of agency MBS; and $1 trillion in additional purchases in 2013 at a pace of $45 billion per month of Treasury securities and $40 billion per month of agency MBS. Because the Federal Reserve has purchased securities in 2013, the first scenario is not possible, but it nevertheless provides a good benchmark for comparing the outcomes of the different scenarios.
Second, we interpret the minutes of the June 2011 FOMC meeting to put some structure on a plausible exit strategy from monetary policy accommodation. These exit principles suggest a sequence of monetary policy actions, starting with allowing SOMA holdings to mature and roll off the portfolio. In our projections, we assume this is the first step to exit the current unconventional monetary policy accommodation. Then we assume that the FOMC begins to raise the target federal funds rate, and finally it sells SOMA assets, in order to normalize the size and composition of the balance sheet within a number of years.
Finally, we rely on the December 2012 Blue Chip Economic Indicators forecast for nominal GDP growth and interest rates. The Blue Chip Economic Indicators is a consensus forecast based on a survey of professional forecasters; we use the mean of the forecast for our selected economic variables for guidance with their projected paths. We assume that the timing of the various elements of the exit strategy is tied to the timing of the liftoff of the federal funds rate. All of these inputs are publicly available and in no way represent a forecast from the Federal Reserve or its staff.
Key findings using the assumptions noted above are the following. First, the projections yield a Federal Reserve balance sheet that remains large by historical standards for a number of years. In particular, the SOMA portfolio expands with asset purchases in 2013 and then contracts at only a slow pace through the medium term, reflecting the fact that as of December 2012, the FOMC suggested that conditions will most likely warrant keeping the federal funds rate at exceptionally low levels for some time.7 Under the assumption of no further asset purchases in 2013, the SOMA portfolio does not return to a more normal size until early 2018. Under the assumption of an additional $1 trillion in asset purchases in 2013, the portfolio returns to a more normal size in early 2019. In either case, the composition of the portfolio does not return to normal until about a year after the size normalizes.
Second, the projections imply that remittances to the Treasury continue at a robust pace through 2015. However, when the federal funds rate increases and securities sales commence, remittances might be halted for a few years, reflecting the elevated interest expense on reserve balances and capital losses associated with sales of MBS, both of which offset the interest income from the portfolio. Federal Reserve Bank accounting rules stipulate that when income is not sufficient to cover expenses, remittances to the Treasury cease, and the Federal Reserve books a "deferred asset."8 In the scenario with no additional purchases in 2013, the projection suggests a low level of remittances for a few years, but no deferred asset. However, larger amounts of securities purchased in 2013 increase the likelihood of a deferred asset. The projection with $1 trillion of additional purchases has a deferred asset for about 4 years, with a peak value of $45 billion. It is important to note that a deferred asset would not have any implications for the FOMC's ability to conduct monetary policy, but remittances to the Treasury would halt. That said, projections for cumulative remittances from 2009 and 2025 are projected to be at least $720 billion, or over $40 billion per year, substantially more than the roughly $25 billion per year remitted prior to the financial crisis. This longer-run perspective on remittances is important, because the remittances fluctuate substantially from year to year in our projections, with earnings being elevated in the near term and falling later as asset sales incur some realized capital losses and interest expense rises temporarily. At the end of the projection period, when the SOMA portfolio grows at its long-run trend, remittances to the Treasury are about $45 billion per year. More broadly, the intent of the asset purchases is to stimulate economic activity and help the Federal Reserve to foster its dual objectives of maximum employment and stable prices. Chung et al. (2011) provide some estimates of the macroeconomic effect of the asset purchases, which would likely result in higher tax revenue, and this effect would likely be substantially larger than any fluctuation in remittances by the Federal Reserve.
Third, Federal Reserve earnings and remittances to the Treasury exhibit sensitivity to the forecast for interest rates. To illustrate these risks to the projections, we consider a scenario where both short-term and longer-term interest rates are 100 basis points higher than in the baseline projection. Relative to the baseline projections, under this assumption, remittances to the Treasury cease for 2 to 3 additional years, and the deferred assets peak at larger amounts. In essence, higher short-term interest rates make interest on reserves more costly, and higher long-term interest rates make selling MBS more costly. We also consider a scenario where rates are 100 basis points lower than in the baseline projection. The lower rates dampen realized losses and interest expense, and as a result, the Federal Reserve remits earnings to the Treasury throughout the projection and no deferred asset is recorded. Under any of the interest rate paths studied here, however, on net, the Federal Reserve's nontraditional policy tends to boost remittances to the Treasury over the projection period in its entirety.
The paper is organized as follows. Section 2 provides a primer on the Federal Reserve's balance sheet and accounting, including the SOMA portfolio and the Federal Reserve's income statement. Section 3 outlines the assumptions used as inputs to the projections of the balance sheet. The balance sheet and income projections are discussed in Section 4, both the projections for the three purchase options under the baseline assumption for interest rates, and the same projections with interest rate shocks that illustrate the interest rate sensitivity of the portfolio. Section 5 concludes. Two appendixes are also included. Appendix 1 provides more detail on the assumptions underlying the projections. Appendix 2 describes the method used to derive projections of future valuations and income from SOMA securities.
In this section, we review key balance sheet components in our projections, as well as the income generated from the balance sheet. We also provide some historical context for the evolution of these items. Discussion of other assets and liabilities can be found in Appendix 1.
Our discussion of the Federal Reserve's balance sheet will refer to the consolidated balance sheets of the 12 individual Reserve Bank balance sheets.9 In reality, the accounting that will be discussed below is done at the Reserve Bank level; however, for simplicity, we focus on the Federal Reserve System's aggregate balance sheet.
Like any balance sheet, the Federal Reserve has assets on one side of the balance sheet, which must equal liabilities plus capital on the other side. As shown in Table 1, at the end of 2006, total assets of the Federal Reserve were $875 billion, with the single largest asset item being the SOMA portfolio, at about $780 billion. Prior to the financial crisis, the domestic SOMA portfolio comprised only Treasury securities, of which roughly one-third were Treasury bills and two-thirds were Treasury coupon securities. On the other side of the balance sheet, the largest liability item was paper currency, or Federal Reserve Notes (FR Notes), at about $785 billion.
With the lending that took place during the financial crisis, for a time, lending of various sorts surpassed the size of the SOMA portfolio. As of December 26, 2012, however, the SOMA portfolio was again the largest asset item, and it had grown to $2.6 trillion because of the asset purchase programs. On the liability side of the balance sheet, FR Notes, at about $1.1 trillion, were no longer the largest liability item. Instead, as the FOMC increased its asset purchases, reserve balances increased correspondingly to a level about $1.5 trillion.
|Assets and Liabilities||billions of $|
|Assets: Other assets||95|
|Liabilities: Deposits of Dis||17|
|Liabilities: FR Notes||783|
|Liabilities: Other liabilities||49|
|Assets and Liabilities||billions of $|
|Assets: Other assets||245|
|Liabilities: Deposits of Dis||1434|
|Liabilities: FR Notes||1100|
|Liabilities: Other liabilities||236|
Source: H.4.1 Statistical Release
The next few subsections review the key components of the Federal Reserve's balance sheet and how they have changed.10
Over most of the post-war period, the SOMA portfolio was the largest asset item on the Federal Reserve's balance sheet.11 During that time, the SOMA portfolio essentially held Treasury securities; however, the portfolio has held other types of securities in its portfolio over its history.12 For example, from 1971 to 1981, the Federal Reserve purchased limited quantities of agency securities; the last of these securities matured in the early 2000s, and none was purchased until 2008.13
Historically, the size of the SOMA portfolio-and the balance sheet more generally-reflected growth in FR Notes and Reserve Bank capital. When currency is put into circulation, it is shipped to a depository institution and that institution's account at the Federal Reserve is debited by an equivalent amount. Because currency outstanding tends to trend upward, over time currency growth would tend to reduce the amount of reserve balances in the banking system. The Federal Reserve would purchase securities in open market operations to offset this drain of reserves. On net, therefore, the growth rate of currency tended to drive the size of the balance sheet. Similarly, when a depository institution is required to subscribe to a larger amount of Federal Reserve capital or the Federal Reserve adds to its surplus account, the result would be-all else equal-a reduction in reserve balances.14 As a result, the SOMA portfolio must increase to offset these increases as well, creating a larger balance sheet overall.
This historical pattern is illustrated in Figure 4. As can be seen, through 2007, both the SOMA portfolio and currency and capital trended upward together. When the asset programs began in late 2008 and early 2009, and continuing through the second round of purchases in 2010 and 2011, the SOMA portfolio increased markedly and at a rate that far outpaced the growth of currency and capital. With the initiation of the maturity extension program in 2011, the size of the portfolio remained roughly constant; however, as depicted in Figure 5, the weighted average maturity of Treasury securities in the SOMA portfolio increased markedly. From a longer perspective, over time, the SOMA portfolio has had a range of maturities of Treasury securities in its holdings.15 Prior to the financial crisis, the Desk tended to purchase securities across the entire yield curve to avoid distorting the yield curve. But after the start of the financial crisis, the maturity of Treasury coupon securities in the SOMA portfolio lengthened notably, reflecting the runoff in bills to sterilize the credit and liquidity programs in 2008, and the purchase of longer-dated securities more recently.
Deposits of depository institutions include all depository institutions' balances at the Federal Reserve that are used to satisfy reserve requirements and balances held in excess of balance requirements. Deposits of depository institutions grew dramatically through the crisis, and are currently quite elevated by historical standards. When we refer to "reserve balances," we are using the "deposits of depository institutions" concept. These deposits represent funds that depository institutions own-they are a liability of the Reserve Bank, but an asset of the depository institution. These funds are also used for payment system settlement-for example, a payment from one bank to another (or from one bank's customer to the customer of a different bank) typically results in a debit to the paying bank's account and a credit to the receiving bank's account. Lending of reserve balances and payment activity result only in a movement of reserve balances from one depository institution's account at the Federal Reserve to another institution's account; the aggregate quantity is unchanged.
Federal Reserve notes, or currency, are a liability of the Federal Reserve. As a practical matter, the quantity of currency outstanding is not determined by the Federal Reserve. Instead, when a depository institution wants to hold currency in its vault or automatic teller machines in order to meet customer needs, it requests a shipment from its Federal Reserve Bank. When that shipment is made, the depository institution's reserve account at the Reserve Bank is debited by the amount of the currency shipment. One important source of demand for U.S. currency is from overseas. Although it is impossible to know with certainty what portion of currency outstanding is outside of the United States, estimates suggest that the fraction is one half or more.16 Prior to the financial crisis, currency was the largest liability item on the Federal Reserve's balance sheet.
The capital of the Reserve Banks is different than the capital of other institutions.17 It does not represent controlling ownership as it would for a private-sector firm. Ownership of the stock is required by law, the Reserve Banks are not operated for profit, and the stock may not be sold, traded, or pledged as security for a loan. As stipulated in Section 5 of the Federal Reserve Act, each member bank of a Reserve Bank is required to subscribe to the capital of its district Reserve Bank in an amount equal to 6 percent of its own capital stock. Of this amount, half must be paid to the Federal Reserve Banks (referred to as capital paid in) and half remains subject to call by the Board of Governors. This capital paid in is a required assessment on the member banks and its size changes directly with the capital of the member banks. Also stipulated by law is that dividends are paid at a rate of 6 percent per year. Over the past decade, reflecting increases in capital at member banks, Reserve Bank capital has grown at an average rate of almost 15 percent per year. In addition, Reserve Banks have surplus capital, which reflects withheld earnings, and Federal Reserve Bank accounting policies stipulate that the Reserve Banks withhold earnings sufficient to equate surplus capital to capital paid in. As a result, as capital of member banks grows through time, capital paid in grows in proportion. Because surplus is set equal to capital paid in, it likewise grows at the same rate as member bank capital.
One liability item is distinct from the others. As noted above, under its remittance policy the Federal Reserve remits all net income to the U.S. Treasury, after expenses and dividends and allowing for surplus to be equated to capital paid in. As those earnings accrue, they are recorded on the Federal Reserve's balance sheet as "Interest on Federal Reserve notes due to U.S. Treasury." In the event that earnings only equal the amount necessary to cover operating costs, pay dividends, and equate surplus to capital paid-in, this liability item would fall to zero because there are no earnings to remit and the payment to the Treasury would be suspended. If earnings are insufficient to cover these costs - that is, there is an operating loss in some period - then no remittance is made until earnings, through time, have been sufficient to cover that loss. The value of the earnings that need to be retained to cover this loss is called a "deferred asset" and is booked as a negative liability on the Federal Reserve's balance sheet under the line item "Interest on Federal Reserve notes due to the U.S. Treasury." As discussed above in footnote 8, it is an asset in the sense that it reflects a reduction of future liabilities to the U.S. Treasury.
One consequence of the current implementation of Federal Reserve Bank accounting policy is that the recording of a deferred asset implies that Reserve Bank capital does not decline in the event of an operating loss. From time to time, individual Reserve Banks have reported a deferred asset; however, these deferred assets were generally short-lived.18 It has never been the case that the Federal Reserve System as a whole has suspended remittances to the Treasury for a meaningful period of time because of operating losses.
As the Federal Reserve's balance sheet has expanded in recent years, the income derived from the balance sheet has also grown, though the key line items from the balance sheet that generated this income are the same. As shown in Table 2, net income in both 2006 and 2011 was driven by interest income from the SOMA portfolio. Despite the difference in magnitude, in both years, SOMA interest income was more than 95 percent of total income. That said, SOMA interest income grew substantially over this period as the SOMA portfolio expanded. Interest expense, on the other hand, was minimal in both years. In particular, FR notes are a large liability without an associated interest expense. And, although the Federal Reserve has paid interest on reserve balances since October 2008, this liability item has incurred little interest expense because the interest on excess reserves (IOER) rate has been at 25 basis points since December 2008. In both years, other items in the income statement were similar. In total, remittances to the Treasury were positive in both years, but much larger in 2011 because of the expanded SOMA portfolio.
|Income and Expenses||billions of $|
|Income: Interest income||36.8|
|Income: Other income||1.6|
|Expense: Interest expense||1.3|
|Expense: Other expense||3.7|
|memo: Additions/deductions dividends and transfers||4.3|
|Income and Expenses||billions of $|
|Income: Interest income||84.5|
|Income: Other income||0.7|
|Expense: Interest expense||3.8|
|Expense: Other expense||4.5|
|memo: Additions/deductions dividends and transfers||1.5|
Source: Federal Reserve Annual Report
The next few subsections review the key line items of the Federal Reserve's income statement in more detail.
As noted above, income on the securities held in the SOMA portfolio constitutes the vast majority of interest income. SOMA interest income primarily reflects the size of the portfolio and the weighted average coupon (WAC) of the portfolio, less any amortized net premiums paid on securities.19 As noted above, prior to the financial crisis, the size of the portfolio increased steadily at a moderate rate. With the adoption of the asset programs, the securities portfolio expanded rapidly and now stands at a level noticeably above its longer-run trend. The WAC, as shown in Figure 6, fluctuated over time, rising and falling with the market rates and the SOMA portfolio's holdings. This pattern primarily reflects the fact that the Federal Reserve reinvests maturing Treasury securities at auction, and the coupon at auction tends to be in line with market rates. Although the asset purchase programs resulted in a significant accumulation of longer-term debt in recent years, much of it was issued in a low-interest rate environment and, therefore, the WAC of the portfolio decreased somewhat.
Putting the size of the portfolio and the WAC of the portfolio together, as shown in Figure 7, interest income climbed at a moderate pace in the years prior to the financial crisis, primarily as a result of the steady increase in the size of SOMA, which rose in line with the growth of FR notes and capital. Beginning in 2009, interest income from the portfolio rose noticeably as large scale asset purchases increased the size of the portfolio.
With the introduction of interest on reserves in the fall of 2008 and the concurrent rise in the level of reserve balances, interest expense rose. As mentioned above, the IOER rate has been 25 basis points since December 2008, and as a result, even with a substantial volume of reserve balances, interest expense from reserve balances has been low compared to interest income and was roughly $3.8 billion in 2011.
In addition to interest expense from reserve balances, there is also interest expense from reverse repurchase agreements (RRPs), mostly generated by the foreign repurchase agreement (RP) pool.20 21 Interest rates paid on the foreign RP pool are generally in line with market rates, and when reserve balances are relatively low, interest expense on the foreign RP pool can represent a large share of total interest expense.
Reverse repurchase agreements with primary dealers and other institutions and the term deposit facility (TDF) also have associated interest expense. In addition to the primary dealers, the Federal Reserve selected money market mutual funds, Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae), and some banks as potential counterparties for RRPs. By contrast to the RRPs, only banks are the counterparties in TDF transactions. Although the Federal Reserve has developed the capability of conducting large-scale operations in either the RRPs or TDF, neither has been used in a material size to date, and as a result, interest expense associated with these facilities has been minimal.
Under Federal Reserve accounting rules, a Federal Reserve Bank realizes gains or losses on a security only when the security is sold. At sale, we calculate the Federal Reserve's gain or loss as the market value minus the par value and unamortized net premiums on the security. Historically, the Federal Reserve did not generally sell securities, because the secular growth in currency resulted in a need for a long-term increase in securities holdings. In 2008, however, the Desk did sell some securities to offset the expansion of the balance sheet that resulted from the introduction of the liquidity facilities at the early stages of the financial crisis. In that year, the Federal Reserve realized a capital gain of roughly $3 billion because market rates had fallen, pushing up the market price of the securities sold. With the maturity extension program, the Federal Reserve has also sold securities. In 2011, these sales realized a $2.3 billion capital gain.
As noted above, member banks are required to subscribe to the capital stock of the Reserve Banks, and the Act stipulates that the Federal Reserve pay a 6 percent dividend on this capital. Under policy prescribed by the Board of Governors, excess earnings are retained as surplus capital in an amount equal to capital paid in. Before remittances to the Treasury are made dividends are paid and earnings are retained to equate surplus to capital paid in. Dividends are paid even if remittances to the Treasury would be zero. As discussed earlier, in the event that earnings fall short of the amount necessary to cover operating costs, pay dividends, and equate surplus to capital paid-in, the Federal Reserve books a liability of "interest on Federal Reserve notes due to U.S. Treasury." This line item is recorded in lieu of reducing the Reserve Bank's surplus, and represents the amount of earnings the Federal Reserve needs to accumulate before it resumes remitting residual earnings to U.S. Treasury.
The Federal Reserve remits any earnings in excess of operating expenses and dividends to the Treasury.22 The use of these funds is stipulated in the Federal Reserve Act, which states:
The net earnings derived by the United States from Federal Reserve banks shall, in the discretion of the Secretary, be used to supplement the gold reserve held against outstanding United States notes, or shall be applied to the reduction of the outstanding bonded indebtedness of the United States under regulations to be prescribed by the Secretary of the Treasury.23
Over time, as shown earlier in Figure 3, remittances remained in a relatively small range, averaging about $25 billion in the years immediately preceding the financial crisis. During the crisis, as Federal Reserve income increased notably, so did remittances to the Treasury. Still, remittances remained a relatively small share of government receipts - dwarfed by individual income and corporate income taxes, as shown in Figure 8, and about in line with customs deposits (not shown).
There are a number of different ways to record the value of the SOMA portfolio. Reserve Bank accounting records the SOMA portfolio at par value. The par value of the portfolio, reported in line 1 of Table 3, gives the face value of the securities in the portfolio. This is the value of the portfolio reported in the weekly H.4.1 statistical release. The amortized cost of the portfolio, also called the book value of the portfolio and shown in line 3, is the par value of the portfolio plus any unamortized net premiums associated with the securities. A third valuation of the portfolio is the market value, line 4. The Federal Reserve Banks Combined Quarterly Financial Reports and the Annual Report also report the fair value (essentially the market value) of the portfolio.24 As interest rates change, the market value of the securities in the portfolio changes. The difference between the market value and the book value is the unrealized net gain (or loss) position of the portfolio, line 5. As of the end of September 2012, the portfolio had an unrealized gain of $249 billion, reflecting a gain on each of the three types of securities holdings.25 September 2012 is the last published information on the position of the portfolio as of the writing of this paper; however, a similar calculation is possible at any time. In particular, the Federal Reserve Bank of New York publishes the CUSIP of every security held in the SOMA portfolio. Combining these CUSIPs with market prices for the securities allows for the calculation-on any day-of the market value of the Federal Reserve's portfolio. A rough calculation of the unrealized gain or loss position of the portfolio is also possible.26
Table 3: Value of the SOMA portfolio as of September 30, 2012 ($ billions)
|Treasuries||Agency Debt||Agency MBS||Total SOMA|
|1. Par value*||1,648||85||848||2,581|
|2. Net premiums||131||1||3||135|
|3. Amortized cost||1,779||86||851||2,716|
|4. Market value||1,968||92||904||2,964|
|5. Unrealized Gain/Loss||189||6||53||248|
Source: Federal Reserve Banks Combined Quarterly Financial Report, September 2012.
In order to construct projections of the Federal Reserve's balance sheet, assumptions about many of the details of the balance sheet and its evolution must be made. The following subsections review assumptions made about key line items of the balance sheet. A detailed description of these and additional line items is found in Appendix 1.
To evaluate the current and future value of securities, and therefore the SOMA portfolio, assumptions must be made about the path of interest rates over the projection period. For this analysis, we rely on interest rate projections from the December 2012 Blue Chip forecast for the federal funds rate and the ten-year Treasury rate. We use the mean quarterly rates from 2012:Q4 through 2014:Q1, the annual rates from 2014 through 2018, and the 5-year average rate from 2019-2023.27 The assumed path for the federal funds rate and the yield on the ten-year Treasury note are shown in Figure 9. The federal funds rate remains in the 0 to ¼ percent range until the first quarter of 2015. This Blue Chip forecast rises slightly earlier than in the October 2012 FOMC statement and subsequent communications by Federal Reserve officials; in other words, the Blue Chip forecast, and therefore the forecast used in this paper, is not the FOMC forecast. After that point, the rate is projected to rise and stand at 3.8 percent in 2025. The yield on the ten-year Treasury note also rises, from its current low level of 1.7 percent to 4.9 percent at the end of the projection period. These forecasts do not represent the views of the Federal Reserve or its staff. The results of the simulations presented in this paper would be different under alternative assumed paths for market interest rates.
To perform the asset valuations that will be required, however, an entire yield curve is needed. As a result, we create a yield curve at each point in time over the projection period using historical relationships between the federal funds rate, the ten-year Treasury rate and selected intermediate tenors. Asset valuation is needed, for example, to project the effect on reserves of selling MBS as envisioned in the FOMC's exit principles-when a security is sold, reserves decline by the sale (market) price of the security, not by the par value. The higher the market value of the security, the more reserves would be drained through the sale. The lower the market value, the reverse would be true. More details are provided in Appendix 2.
This subsection reviews our projection methodology for selected asset and liability items that are of particular interest. All elements of the balance sheet are projected, but we leave those of less interest to Appendix 1.
The evolution of the SOMA portfolio is intended to be consistent with the FOMC statement on December 12, 2012. In particular, we assume:
Given the initial composition of the SOMA portfolio on October 31, 2012, the portfolio evolves over time. We adjust the maturity structure of holdings of Treasury securities and agency securities through time to reflect (1) through (3) and the passage of time. Moreover, the forecast for future purchases imposes the assumed constraint that SOMA holdings that any one CUSIP remain below 70 percent of the total amount outstanding in that CUSIP, as announced by the Federal Reserve Bank of New York.
Similar to the use of Blue Chip projections for interest rates, we turn to public projections for the Treasury's issuance of marketable debt. We use projections of both the amount and the maturity of Treasury issuance in order to project securities available for purchase by the Federal Reserve. We use Treasury issuance as of October 2012, and from that point forward, coupled with the Congressional Budget Office's January 2012 projections for total Treasury debt outstanding, we generate the level and maturity structure of marketable debt outstanding.29 In addition, we assume that the average maturity of Treasury debt outstanding extends from its current level of 62 months to 70 months by 2015, roughly consistent with the Treasury's stated intentions as of November 2011 and August 2012.30 Therefore, future Treasury purchases are associated with coupons that evolve over time reflecting projections in interest rates, Treasury issuance, and the 70 percent ownership rule.
A couple of particulars regarding Federal Reserve accounting and valuation of securities should be noted. Specifically, Federal Reserve accounting records the securities holdings at face value and records any unamortized premium or discount in the "other assets" category. Consequently, we must project both the face value of the portfolio and the associated premiums. To project premiums on future securities purchases we need to calculate the market value of securities in the future. We take the market value for securities as the present discounted cash flow of these securities using the coupon rate to generate cash flows and the yield curves described in Section 3.1 and Appendix 2 to discount these cash flows. The premium is the difference between the face value and the market value of the security. Treasury securities that are rolled over at auction are assumed to be purchased at par, and therefore have no premium.
For MBS reinvestment, we need to project the coupon of the securities that will be purchased. The model used for that is described in Appendix 2. Because reinvestments are assumed to continue only in the near term, we assume that purchases of MBS take place at a price 4 percent above face value, consistent with recent MBS reinvestment activity.
In our modeling, two items are important exogenous drivers of the balance sheet contour - FR notes and capital paid in. For simplicity, we assume that FR notes grow in line with the Blue Chip forecast for nominal GDP. Capital paid in is assumed to grow at its decade average of 15 percent per year, and surplus is equated to capital paid in. This growth rate plays a role in the long-run trend growth rate of the SOMA portfolio.
Reserve balances, an important liability item for the Federal Reserve, are endogenous to our projections and in general calculated as the residual of assets less other liabilities less capital in the balance sheet projections. However, we assume a minimum level of $25 billion is set for reserve balances. That level is roughly consistent with the level of reserve balances observed prior to the financial crisis. Both FR Notes and capital are trending higher in these projections. To maintain reserve balances at $25 billion, we assume that the Desk begins to purchase Treasury bills. Purchases of bills continue until these securities comprise one-third of the Federal Reserve's total Treasury security holdings - as noted above, about the average proportion of Treasury holdings prior to the crisis. Once this proportion of bills is reached, we assume that the Desk buys coupon securities in addition to bills to maintain an approximate composition of the portfolio of one-third bills and two-thirds coupon securities.
For the near-term projections, we note that the FOMC completed the MEP and $40 billion in MBS purchases in December 2012, and assume the FOMC begins one of the three purchase scenarios ($0, $500 billion, or $1 trillion) in 2013. Further out in the projection period, we base our projections on the general principles for the exit strategy that the FOMC outlined in the minutes of the June 2011 FOMC meeting.31 The Committee stated that it intended to take the following steps in the following order:
These principles represent a rough guide to the exit strategy. In particular, at that time, the Committee stated that is prepared to make adjustments to its exit strategy if necessary in light of economic and financial developments.
To complete the projections, however, we need to make additional assumptions. We tie changes in the SOMA portfolio to the date the federal funds rises from its effective lower bound, which, based on the Blue Chip forecasts, we assume is March 2015. We assume that the reinvestment of securities ends six months before this date. We do not explicitly model the use of reserve-draining tools.32 We assume that sales of agency securities begin six months after the federal funds rate begins to rise and that the balance sheet has returned to normal size over about three years. In interpreting "normal size" we rely on the $25 billion minimum level for reserve balances as "normal." We summarize the assumed exit strategy in Table 4.33
|Assumption||$0 2013 Purchases||$500bn 2013 Purchases||$1tr 2013 Purchases|
|MEP Treasury Purchases: Amount||$667 billion||$667 billion||$667 billion|
|MEP Treasury Purchases: Length||15 months||15 months||15 months|
|MEP Treasury Purchases: First month||Oct-11||Oct-11||Oct-11|
|MEP Treasury Purchases: Last month||Dec-12||Dec-12||Dec-12|
|MEP Treasury Sales or Redemptions: Amount||$667 billion||$667 billion||$667 billion|
|MEP Treasury Sales or Redemptions: Length||15 months||15 months||15 months|
|MEP Treasury Sales or Redemptions: First month||Oct-11||Oct-11||Oct-11|
|MEP Treasury Sales or Redemptions: Last month||Dec-12||Dec-12||Dec-12|
|Current Portfolio Strategy: Agency reinvestments||Agency MBS||Agency MBS||Agency MBS|
|2013 Treasury and MBS Purchases: Amount||N/A||$500 billion||$1 trillion|
|2013 Treasury and MBS Purchases: Length||N/A||6 months||12 months|
|2013 Treasury and MBS Purchases: First month||N/A||Jan-13||Jan-13|
|2013 Treasury and MBS Purchases: Last month||N/A||Jun-13||Dec-13|
|2013 Treasury and MBS Purchases: MBS purchase pace||N/A||$40bn/month||$40bn/month|
|2013 Treasury and MBS Purchases: Treasury purchase pace||N/A||$45bn/month||$45bn/month|
|Exit Strategy: Fed Funds liftoff||Mar-15||Mar-15||Mar-15|
|Exit Strategy: Redemptions start||Sept-14||Sept-14||Sept-14|
|Exit Strategy: Agency sales|
|Exit Strategy: Sales start||Sept-15||Sept-15||Sept-15|
|Exit Strategy: Sales end||Aug-19||Aug-19||Aug-19|
Other line items on the balance sheet continue on their projected path as noted above.
Based on projections of the size and composition of the Federal Reserve's balance sheet, a projected path for interest rates, and some other assumptions, we can calculate an implied projection for the Federal Reserve's earnings, expenses, and remittances to the Treasury. Again, the details of Reserve Bank accounting matter, but we will discuss the primary determinants, which are interest income, interest expense, capital gains or losses, and remittances to the Treasury. This section describes the key assumptions behind the income projection, while Appendix 1 provides additional details.
Not surprisingly, since the SOMA portfolio is the largest asset item, it generates the bulk of Federal Reserve Bank earnings. Interest income reflects the coupon payments from the SOMA portfolio's holdings of securities minus the amortization of premiums on those holdings. To create the projections of interest income, therefore, we must track the evolution of the portfolio from purchases, sales, and maturing securities. As the composition of the portfolio evolves, the coupon on the portfolio evolves. The amortization of premiums reduces interest income, so the assumptions about the premiums on the securities purchased affect the calculation of interest income.
Focusing on income from Treasury securities, for simplicity, we divide the SOMA portfolio holdings into "buckets" by maturity instead of analyzing each CUSIP. Specifically, we aggregate CUSIPS by month of maturity, treating all securities maturing within a given month as a single security. Based on these buckets, we calculate the WAC of the portfolio and multiply that by the holdings. Next, we subtract off amortized net premiums.
The projection of the SOMA portfolio and the associated premiums were discussed in Section 3.2.1. As of October 31, 2012, the WAC of the Treasury portfolio is known. For the projection, we separate purchases of securities from reinvestment. Purchases occur in the secondary market at projected market prices. Over time, the average coupon on Treasury securities in the secondary market evolves as existing Treasury issuance ages and projected new issuance is introduced into the market. The starting point of the coupon rates of existing Treasury securities are from the Treasury's Monthly Statement of the Public Debt as of October 31, 2012. We assume that any purchases in the secondary market in a targeted bucket have an average coupon rate equivalent to the average coupon of Treasury securities in the market with remaining maturity in this bucket. As a result, we calculate the current market value of the securities to compute the implied premium. Reinvestment of maturing securities, however, is done at auction, and we assume that newly auctioned securities are issued at par, and therefore have no premium associated with them. For reinvestment, we project future coupon rates on newly issued Treasury securities using a regression-based term structure model as outlined in Appendix 2.
For holdings of MBS, we separate MBS purchased during the first large-scale asset purchase program from November 2008 to March 2010 and the reinvestment policy through October 2012, and those projected to be reinvested and purchased in 2013 and beyond. This distinction is important because the coupons on MBS purchased under the asset program are generally higher than the current production MBS. The MBS currently held on the Federal Reserve's balance sheet have coupons that range from 2.5 to 6.5 percent. The higher coupon securities tend to have higher premiums associated with them. MBS reinvestment is assumed to take place in current-coupon securities, which have been purchased at a premium that is assumed to be 4 percent above face value.
Over much of the Federal Reserve's history, interest expense has been modest. Interest expense derives from interest-bearing liabilities, in particular the foreign reverse repurchase agreement pool and reserve balances. Over the past decade or so, the foreign repo pool has averaged roughly $50 billion and pays interest at a rate consistent with overnight repo rates. As a result, this interest expense is relatively small. As mentioned above, prior to 2008, the Federal Reserve did not have the authority to pay interest on reserve balances. Currently, although reserve balances are quite elevated, at $1.5 trillion, the IOER rate is 25 basis points at an annual rate, which implies less than $4 billion paid in interest over the course of this year. Interest rates are projected to rise, however, and we assume that the IOER rate will be equal to the federal funds rate.34 As a result, interest expense will rise. But, in the projections, reserve balances are projected to decline, so the net effect on interest expense depends critically on the timing of the rise in interest rates and the decline in reserve balances.
Federal Reserve Bank accounting only realizes gains or losses on the SOMA portfolio if a security is sold, and historically, the Federal Reserve sold securities infrequently.35 In 2011, MEP sales recorded a slight capital gain. In addition, prepayments on MBS result in a realization of a gain or a loss on that security based on the amount of the prepayment.36 For these projections, we calculate capital gains (losses) as the market value of the securities being sold minus their par value and unamortized net premiums. The market value is calculated using the yield curves and discounted cash flow methodology described in Appendix 2. In determining the Federal Reserve's income in a given period, after the earnings and expenses discussed above are calculated, capital gains (losses) are added.
The various other components that contribute to net income are small and noted in Appendix 1. Two additional adjustments to net income are made before the calculation of remittances to the Treasury is complete. As noted above, the Federal Reserve is statutorily required to pay dividends to member banks. In addition, the Reserve Banks transfer funds to a surplus capital account to ensure that surplus always equals capital paid in. Remittances to the Treasury in any period are calculated as all remaining net income after these adjustments. Remittances to the Treasury, however, can never be negative. As noted above, if there is an operating loss in some period, then no remittance is made until earnings, through time, have been sufficient to cover that loss. The value of the future earnings that will be retained to cover this loss is a deferred asset.
In this section, we begin with three options for the projection of the balance sheet: no purchases in 2013, $500 billion in purchases in 2013; and $1 trillion in purchases in 2013. These baseline scenarios provide a useful guide to how the Federal Reserve's balance sheet might evolve under a range of possible assumptions. Next, we examine a scenario where interest rates are uniformly 100 basis points higher than in the baseline after lift-off. Although this shock-particularly the parallel shift-is an unlikely outcome, we present it to show the interest rate sensitivity of the portfolio. As will be shown, the contours of the projections in the shock scenario are similar to those under baseline assumptions for interest rates, but the size of capital losses is larger, interest expense is higher, and remittances are therefore lower. Finally, we discuss a scenario where interest rates are 100 basis points lower than in the baseline after liftoff. Again, the contours of the projections are similar to the baseline, with losses and interest expense somewhat lower. We stress again that these projections are the result of the underlying assumptions made about interest rates and policy decisions and, as a result, are not forecasts themselves. The point of the analysis here is to establish a framework for such projections, and different assumptions would, in general, result in different projections.
Figures 10 and 11 present the projections of key balance sheet line items under our three baseline scenarios. As shown in the top left panel of Figure 10, SOMA holdings move up slightly through the end of 2012 reflecting the $40 billion per month purchases of MBS. In 2013, under with no further purchases (the solid line), the portfolio remains fairly steady at its end-2012 level.37 With $500 billion or $1 trillion in further purchases (the blue dashed and red dotted lines, respectively), the portfolio rises through 2013, growing at $85 billion per month. The peak size of the portfolio reflects the size of the purchase program: with no further purchases, the portfolio reaches $2.75 trillion, with $500 billion, $3.25 trillion, and with $1 trillion, $3.75 trillion. The level of reserve balances reflect the asset programs, with reserve balances topping out at $1.7 trillion, $2.2 trillion and $2.7 trillion in the zero, $500 billion, and $1 trillion asset purchase programs, respectively. After purchases end, under the assumption that the FOMC begins to allow all asset holdings to roll off the portfolio as the first step in the exit strategy, with the timing implied by the interest rate projections, SOMA holdings begin to decline. Notice that SOMA Treasury holdings, the top right panel, remain constant even when roll off begins. This fact is a result of the MEP reducing holdings of shorter-dated Treasury securities to near zero. MBS holdings, the bottom left panel, on the other hand, begin to contract. Beginning in September 2015, again consistent with our assumptions about the exit strategy, MBS sales begin, and these holdings fall to zero by August 2019. In the no further purchases scenario, the size of the balance sheet is normalized in April 2018 (32 months after sales begin), while in the $500 billion and $1 trillion purchase scenarios, normalization occurs in October 2018 (38 months) and February 2019 (42 months), respectively.38
The reduction in the size of the SOMA portfolio, along with the projected growth of Reserve Bank capital and FR notes, results in declines in the level of reserve balances, shown in the bottom right panel of Figure 11. As described above, we assume that reserve balances are not allowed to fall below $25 billion. Therefore, by early 2019 in all scenarios, these projections assume that the Desk again starts to reinvest maturing Treasury securities and begins purchases of Treasury securities. After this point in time, the SOMA portfolio expands in line with FR notes and capital and reserve balances remain constant - and unconventional monetary policy has essentially unwound.
Figure 12 shows the path of Reserve Bank net income under the three baseline scenarios. Because of the large size of the SOMA portfolio, interest income is elevated through 2015 in all scenarios, with the larger portfolios having higher interest income. As the SOMA portfolio begins to contract with the assumed steps in the exit strategy, interest income declines through mid-2018. After reserve balances reach $25 billion, Treasury purchases resume, expanding the portfolio, causing interest income to rise.
As noted above, interest expense reflects both the level of the federal funds rate and the level of reserve balances. The federal funds rate in the Blue Chip forecast begins to rise in 2015, and interest expense rises with it. However, in 2016, interest expense begins to moderate, as the decline in reserve balances more than offsets the rise in the federal funds rate.
In terms of capital gains or losses, Treasury securities sales conducted under the MEP result in a small gain because of the low level of market interest rates in 2012 and the relatively higher coupon on the securities sold.39 During the exit strategy, however, MBS sales result in realized losses. Over the four-year sales period, September 2015 to August 2019, these losses average roughly $18 billion per year across all three scenarios. This amount may seem notable but should be compared to the cumulated earnings from the larger portfolio.
On net, remittances to the Treasury remain elevated by historical standards through 2015, but then decline. For the scenarios with additional purchases in 2013, remittances fall to zero for a number of years, reflecting some realized losses associated with sales and higher interest expense, and a deferred asset is recorded. The larger the program, the larger the sales and interest expense, and so the larger is the peak deferred asset.
For the $1 trillion purchase scenario, there is a deferred asset that lasts for four years and that peaks at $40 billion. For comparison, the surplus capital account-that is, retained earnings-is about the same size as this peak, and the average annual remittances to the Treasury over the projection period is slightly larger. Once sales are completed and the portfolio reaches its steady state growth path, remittances to the Treasury rise slowly as the portfolio expands and interest income rises. Remittances in 2025 are close to $45 billion.
When comparing the cumulative remittances generated from alternate programs, the $1 trillion program, which results in the largest deferred asset, results in cumulative remittances that are roughly $60 billion below the scenario with no further purchases, or roughly $5 billion less on average per year. Of course, the overall effect on the federal government's finances is more complicated. For example, if these additional asset purchases provide meaningful economic stimulus, the increase in government revenues from faster economic growth could more than offset the reduction in remittances. Further, if the asset purchases lower interest rates, the interest expense of the federal government is lower.
As discussed above, only realized gains or losses affect the Federal Reserve's income. Nevertheless, given the large SOMA portfolio and the projected rise in interest rates, under the baseline projections, the portfolio is in an unrealized loss position beginning in 2014. This unrealized loss position continues to grow through 2017, but subsequently diminishes as the portfolio shrinks through redemptions and sales.
Policymakers have also discussed the interest rate sensitivity of the SOMA portfolio and the implications of large increases in interest rates on Federal Reserve net income.40 To explore this possibility, as shown in Figure 9 under the higher interest rate scenario (the dashed line), the federal funds rate and ten-year Treasury yield rise at a faster pace at lift off, and after one year are 100 basis points higher than the baseline rates over the remainder of the projection period. One could imagine an increase in inflation or inflation expectations could lead to such a result; modeling this type of economic environment is beyond the scope of this paper and the shock is used solely to demonstrate in the interest rate sensitivity of the portfolio. We note, however, that this shock is broadly consistent with the ten highest interest rate projections from respondents to the Blue Chip survey. In other words, these interest rates are at the high end of market expectations, but are seen as plausible outcomes by professional forecasters. In the baseline interest rate projection, the ten-year Treasury yield rises by 2 percentage points between end-2014 and end-2016. By contrast, the 100 basis point shock implies the ten-year Treasury yield is increasing by 3 percentage points over these two years.
There are a couple of ways to put the size of this shock in perspective. To start, this size shock is above that expected by the respondents to the December 2012 Blue Chip survey with the top ten highest interest rate expectations (roughly 20 percent of the sample), and thus is probably comfortably above most market participants' interest rate projections. In addition, for a historical comparison, from 1978 to present, the standard deviation of the two-year change in the 10-year Treasury yield is 1.6 percentage points. As a result, this higher-interest rate scenario should be seen as a somewhat unlikely scenario, but not an implausible one. Of course, to the extent that inflation expectations have become better anchored through time, this increase in interest rates may be even less probable than the historical record may suggest.
The interest rate shock does not change the broad contours of the Federal Reserve's balance sheet, as shown in Figure 13. The higher interest-rate path does, however, change the income projections notably, and as a result, leads to a different path of remittances to Treasury. Broadly speaking, the higher interest-rate path reduces remittances as interest expense rises and losses on securities sales grow. In the longer-run, after the size of the balance sheet normalizes, the higher coupon rate on Treasury securities purchased to keep pace with the growth of the Federal Reserve's balance sheet actually pushes up remittances.
The specifics of the income projections with higher interest rates are shown in Figure 14. SOMA interest income remains similar to the baseline because the securities in the SOMA portfolio have already been purchased and their coupons are fixed. However, interest expense becomes greater once the federal funds rate lifts off from the lower bound because of the higher interest rate path. In addition, because sales of MBS occur when longer-term interest rates are higher than in the baseline, realized capital losses are somewhat greater. Overall, in the scenario with no additional asset purchases in 2013, the higher interest rates cause remittances to the Treasury to fall to zero and a small deferred asset is created. In the scenario with $1 trillion additional asset purchases in 2013, in the higher-interest rate scenario, the deferred asset peaks at $125 billion, substantially higher than under the baseline. Moreover, remittances to the Treasury are halted for 6½ years. This reduction in earnings in this scenario reflects the interest rate risk that the Federal Reserve is taking on with asset purchases. More purchases tend to lead to larger realized losses, and the losses are even larger under the higher-interest rate scenario. For comparison, however, in the higher-interest rate scenario, cumulative remittances are only about $45 billion lower than in the scenario without the interest rate shock. Under all scenarios, remittances to the Treasury resume by end-2022. As noted above, to the extent that the policies are effective in stimulating the economy, overall government revenues would be boosted on net, despite the somewhat higher losses at the Federal Reserve.
These outcomes, however, should be viewed in a longer-term context. Overall, average annual remittances to the Treasury even in this shock scenario remain above the average annual remittances of $25 billion recorded prior to the crisis.
Just as it is possible for rates to be higher than projected by the Blue Chip consensus forecast, rates may be lower than the consensus forecast. In order to characterize this possibility, Figure 15 displays the federal funds and 10-year Treasury yield under the assumption that the rise in rates is neither as high nor as fast as in the baseline consensus forecast, and in the long-run, rates are 1 percentage point lower than in the baseline. Possible scenarios that could produce this outcome through the medium run include a slower or weaker recovery than currently expected by market participants. Rather than rising by 200 basis points in the longer run, the 10-year yield moves up only 100 basis points, a modest level compared to longer-run averages. This path is broadly consistent with the ten lowest interest rate projections from the respondents of the Blue Chip survey.
As shown in Figure 16, and similar to the higher interest rate shock, the lower interest rate shock does not change the broad contour of the balance sheet projection. Nevertheless, the income projection and therefore remittances to the Treasury does materially change, as shown in Figure 17. In general, the lower interest rate path mitigates losses from sales of agency MBS and dampens expense from reserve balances, boosting remittances relative to the baseline to some degree. As a result, regardless of the amount of purchases in 2013, remittances to the Treasury stay positive in all years of the projection and no deferred asset is recorded on an annual basis. Mirroring the results in the higher interest rate scenarios, in the longer-run, the lower coupon rate on Treasury securities purchased to keep pace with the expansion of the balance sheet depresses remittances relative to the baseline case. However, despite the lower remittances at the end of the projection period, average annual remittances in the projection still remain well above the average annual level before the crisis.
In this paper, we have outlined the mechanics of and projections for the Federal Reserve's balance sheet and income. Under the baseline projections, derived from publicly available forecasts about the economy and public statements by the FOMC, the Federal Reserve's balance sheet is substantially larger than it had been historically for some years until contracting gradually during the expected exit period, and only returning to its long-run growth path in late 2018 or early 2019. This result, if it is expected by market participants and were to be realized in practice, would imply that unconventional monetary policy actions would be holding interest rates down, to some degree, for a number of years. The Federal Reserve's income and remittances to the Treasury are projected to remain at historically elevated levels for a few more years, reflecting the relatively high yields earned on longer-term Treasury securities and MBS. However, remittances subsequently decline for a time. Given the FOMC's stated plan to sell MBS at the time that policy accommodation is being removed, some losses are projected to be realized on those sales. Moreover, the elevated level of reserve balances is projected to lead to increasing interest expense for some time. Taken together, remittances to Treasury are projected to fall to a low level or to be halted for a few years and a deferred asset will be booked on the Federal Reserve's balance sheet. Subsequently, the Federal Reserve's income is projected to return to its longer-term trend and remittances to the Treasury rebound.
To demonstrate the interest rate risk on the portfolio, and to underscore the fact that these projections are not forecasts per se, but rather, the result of a set of assumptions, we consider how income may evolve with a 100 basis point shock upwards or downwards to the baseline interest rate paths. Overall, higher interest rates result in higher realized losses on MBS sales and higher interest expense, both of which contribute to a larger deferred asset, all else equal. On the other hand, lower interest rates generate lower realized losses and lower expense, and consequently, no deferred asset is recorded. In all of the simulations, however, looking at cumulative remittances to the Treasury over the period of the use of the balance sheet as a tool for policy suggests that Federal Reserve earnings are boosted, on net, from these actions. That result suggests that the Federal Reserve is not imposing a cost on the Treasury, but instead, however incidentally, providing additional revenues. Of course, any and all of the results are a reflection of the assumptions, and none of the assumptions used in the analysis reflect official views of the Federal Reserve. Rather, the assumptions are derived from publicly available information.
Board of Governors of the Federal Reserve System. 1976. Banking and Monetary Statistics, 1914-1941.
Carpenter, Seth, Ihrig, Jane, Klee, Elizabeth, Boote, Alexander, and Quinn, Daniel. 2012. "The Federal Reserve's Balance Sheet: A Primer and Projections," Finance and Economics Discussion Series no. 2012-56, Federal Reserve Board, August.
Chung, Hess, Laforte, Jean-Philippe, Reifschneider, David, and Williams, John C. 2011. "Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?" Federal Reserve Bank of San Francisco Working Paper 2011-01, January.
Edwards, Cheryl E. 1997. "Open Market Operations in the 1990s," Federal Reserve Bulletin, p. 859-874.
Federal Reserve Bank of New York. 2011. "Domestic Open Market Operations in 2010," available for download at http://www.newyorkfed.org/markets/Domestic_OMO_2010_FINAL.pdf
Garbade, Kenneth D., Partlan, John C., and Santoro, Paul J. 2004. "Recent Innovations in Treasury Cash Management," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 10, no. 11, November.
Gurkayank, Refet, Sack, Brian, and Wright, Jonathan. 2007. "The U.S. Treasury yield curve: 1961 to the present," Journal of Monetary Economics, p. 2291-2304, November.
Ihrig, Jane, Klee, Elizabeth, Li, Canlin, Schulte, Brett, and Wei, Min. 2012. "Expectations about the Federal Reserve's Balance Sheet and the Term Structure of Interest Rates," forthcoming Federal Reserve Finance and Economics Discussion Series paper.
Judson, Ruth, and Porter, Richard. 1996. "The Location of U.S. Currency: How Much is Abroad?", Federal Reserve Bulletin, vol. 82, p. 883-903, October.
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This appendix provides details about the forecasting procedure for each balance sheet item. Those not specifically discussed are held at their level as of October 31, 2012.
SOMA Treasury holdings are assumed to evolve through a combination of outright purchases and outright sales in the secondary market, reinvestment at auction, and maturities.
Maturity Extension Program purchase distribution (percent)
|6-8 years (Nominal coupon securities)||8-10 years (Nominal coupon securities)||10-20 years (Nominal coupon securities)||20-30 years (Nominal coupon securities)||TIPS|
2013 Treasury purchases distribution (percent)
|4 - 4.75 years (Nominal coupon securities)||4.75 - 5.75 years (Nominal coupon securities)||5.75 - 7 years (Nominal coupon securities)||7 - 10 years (Nominal coupon securities)||10 - 17 years (Nominal coupon securities)||17 - 30 years (Nominal coupon securities)||TIPS|
|Year||CBO debt held by the public ($ Billion)|
|Buckets||October 2012 Issuance by bucket ($ Billion)||Initial shares of issuance|
|Year||Blue Chip nominal GDP growth forecast|
The projections for the coupon rates on Treasury securities depend on forecasts for the yield curve. We construct a zero-coupon yield curve using projections for the federal funds rate and the forecast for the 10-year Treasury yield, where these independent variables are taken from the adjusted December 2012 Blue Chip forecast for future interest rates.
We specify the relationship between a yield at tenor i and these rates using a regression:
The estimated coefficients and associated R-squared statistics are displayed in the appendix table A2-1. In general, the results are in line with intuition and these two rates can explain almost all the variation in the other rates. In addition, we performed a series of robustness checks. Specifically, longer-term rates tended to exhibit cointegration with the 10 year rate, but shorter-term rates did not. Overall, the estimated coefficients and resulting yield curves presented here are broadly similar to those using a cointegrated or other type of specification.
With these estimates in hand, we then construct "initial" yield curves for each point in time in our forecast, interpolating values for tenors for which we do not explicitly estimate a model. We use these for our projected coupons on Treasury securities we purchase over the forecast period.
An additional estimate is needed to forecast the coupon rate on future MBS purchases. This is done by estimating the statistical relationship between the Fannie Mae MBS current coupon rate, the 10-year Treasury rate, and the 30-year fixed-rate mortgage rate. We use quarterly averages of daily data from 1984Q4 to 2011Q3 to generate our parameter estimates. We use an AR(3,1,0) model to account for the autocorrelation in the error terms and the cointegration in the two series. As is evident from table A2-2, changes in the 10-year rate and 30-year fixed-rate mortgage rate are matched almost one-to-one with those in the MBS current coupon rate, and the autocorrelation in the differenced series, while not strong, is still persistent enough to be relevant in tests for autocorrelation of the residuals.
|Year||Effective rate Coefficient||Effective rate Standard error||Effective rate T-stat||10-year rate Coefficient||10-year rate Standard error||10-year rate T-stat||Constant Coefficient||Constant Standard error||Constant T-stat||R-squared|
|(30yr fixed-rate mortgage rate)||0.858||0.059|
|AR Term L1||-0.254||0.109|
|AR Term L2||-0.07||0.111|
|AR Term L3||-0.242||0.121|