An interesting experiment that we are likely to observe

Article Highlights

  • The Fed now has $3.7tn in long-term bonds and mortgage securities on its balance sheet.

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  • Does the market or the world care if the world’s principal central bank is insolvent on a mark-to-market basis?

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  • The government is not the shareholder of the Federal Reserve Banks – the stock is entirely owned by the commercial banks which are “members” of the Fed.

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Sir, John Plender (“Can Yellen’s Fed sidestep the lurking monsters?”, December 18) correctly points out the “threadbare” capital ratio of the Federal Reserve and says not much of a rise in interest rates would “throw it into technical insolvency”. He’s right.

Let’s do the numbers. The Fed now has $3.7tn in long-term bonds and mortgage securities on its balance sheet. It does not disclose the duration of this massive portfolio, but seven and a half years might be a fair guess. Let’s consider a modest rise in interest rates of 2 per cent. The mark-to-market loss would then be 2 x 7.5 per cent x $3.7tn or about $555bn. How much capital does the Fed have? $55bn. So the mark-to-market loss would be about 10 times its capital. Of course, the increase in interest rates and thus the loss in value could be more than that.

Does the market or the world care if the world’s principal central bank is insolvent on a mark-to-market basis? Quite possibly not. But it would an interesting experiment to find out – an experiment that we are quite likely to observe.

Mr Plender goes on to speculate about a possible “formal recapitalisation” of the Federal Reserve and seems to assume that this recapitalisation would come from the government. But the government is not the shareholder of the Federal Reserve Banks – the stock is entirely owned by the commercial banks which are “members” of the Fed, as required by the Federal Reserve Act. What their role in a recapitalisation might be is another interesting speculation.

Alex J Pollock, Resident Fellow, American Enterprise Institute, Washington, DC, US

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