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The Federal Reserve's $4.3 trillion ticking time bomb

The Federal Reserve has a big problem if it wants to raise rates again. It will have to pay U.S. and foreign banks enormous sums of money instead of U.S. taxpayers.

Not only would the Fed likely draw the ire of Congress, but it could also become a target of the next U.S. president—be it Clinton or Trump. That’s because the gangbuster profits of $90 billion (plus) per year that the Fed remits to the Treasury could easily dwindle to zero. According to several leading economists, it’s also possible that the Fed will become technically insolvent (though it always has the power to print its way out of such a disastrous state).

Quantitative easing was a Faustian bargain

The putative savior of the financial crisis, quantitative easing, was a Faustian bargain. The Fed got to inject trillions of dollars into the financial sector while simultaneously “sterilizing” the very same money. It did this by incentivizing banks to deposit their digital cash at the Fed, paying above-market interest rates.

Currently, the Fed pays 0.50% annually to banks to keep that money out of the economy. It might not seem like much, but the comparable rate paid by the U.S. Treasury for T-bills is 0.28%. In other words, the Fed pays banks nearly twice as much as the Treasury does.

But the Fed refuses to acknowledge this. Each year, the Fed Chair is required by law to testify twice in front of Congress. Both Ben Bernanke and Janet Yellen have used the word, “comparable,” to assert disingenuously that the Fed is paying an amount of interest similar to what banks could earn in the marketplace. It’s possible to “compare” apples to oranges, but it doesn’t mean they’re similar.

Currently, the Fed is paying banks about $12 billion per year in interest. If the Fed raises rates two times (by 0.25% each time) and the level of reserves stays the same, that number doubles to $24 billion. If we are to believe San Francisco Fed President John Williams, who targets an eventual 3.0% for short-term rates, then that's $72 billion per year to the banks. This is a huge expenses for the Fed. Subtract from that the $90 billion (plus) per year in operating profits, and the amount of money the Fed pays to the Treasury gets pretty small.

The Fed is poised to take huge capital losses

But it gets worse. The Fed is taking capital losses on its $4.3 trillion bond portfolio, and those losses will eventually accelerate. When the bonds that the Fed holds mature, it realizes losses because it paid above-market prices for most of them to begin with.

The Fed is currently keeping its balance sheet the same size, purchasing new bonds when old ones mature. Should it decide to sell bonds, it would realize huge losses over a short space of time and would likely go into debt with the U.S. Treasury. According to Hall and Reis, it would take the Fed 6 to 10 years to work off the debt and get back in the green.

Bottom line: No matter how you slice it, the Fed payments to Uncle Sam will not only drop off a cliff someday, they could also go negative. That means, the taxpayers would be indirectly on the hook for Federal Reserve operating losses.

The crisis comes when Congress realizes the Fed is paying the government nothing (or next to nothing) while shelling out billions to the banks. Several members of Congress have already been critical of Fed payments to banks, but they’ve largely missed the mark. When the next budget crisis arises without the Fed paying it’s perceived “fair share,” all it would take is a few impassioned speeches to stir the masses and make monetary policy a de facto political animal.

The worst possible outcome would be for a fickle and indecisive Congress to assert its authority over monetary policy. Unfortunately, by waiting seven years to raise rates—and into an economy growing at best modestly—the Fed has backed itself into a corner. The Fed has clearly chosen the banks over the best interests of the taxpayers, and this will eventually come back to bite Chair Yellen.