We send this note as a follow-up to ongoing comments about the size of central banks’ balance sheets, equity or lack thereof, and the guest commentary by Alex Pollock regarding the Swiss National Bank. The link that follows is to a May 26, 2015, discussion at Money and Banking that we think readers will find helpful: https://www.moneyandbanking.com/commentary/2015/5/26/do-central-banks-need-capital.
We are also sending the link to the “Bailout Barometer” calculated by the Federal Reserve Bank of Richmond. It is worthwhile to take the time to review the way it is calculated and how it reflects federal risk. We note that the methodology used in the calculation has been fluid, although since the financial crisis ended in 2009, the estimate that about 60% of all financial firms’ liabilities are subject to protection by the federal safety net has held steady. Note that this figure is up from about 45% at the turn of the millennium. For details from the Richmond Fed, see https://www.richmondfed.org/publications/research/special_reports/safety_net.
Let’s go back to Alex Pollock. In my correspondence with him, Alex added some info about the Congressional Budget Office 10-year estimates (2015-2025) that cover the interest costs of the federal budget if rates rise. Note that the CBO must follow a prescribed method. I thought about interest-rate sensitivity and asked Alex how he viewed the remittances from the Fed to the US Treasury. The Fed is holding over $4 trillion in federally backed paper. If the Fed’s balance sheet were to shrink to once again match the pre-crisis formula (assets held equaled mostly required bank reserves plus currency outstanding), it would likely be about $1.5 trillion in size, which means the market would have to absorb about $3 trillion of federal assets disgorged by the Fed. Many of those assets are included in the Richmond Fed Barometer.
[Read: Clouds on the Horizon for the US Federal Budget]
Alex brought in Alan Viard, an American Enterprise Institute colleague, who directed us to pages 132-133 of Appendix C of the CBO report. In sum, the CBO estimate assumes that the Fed’s balance sheet remains static. It therefore concludes that a rise in rates will work itself out over time and that the remittances will eventually neutralize. In other words, the federal government has to pay a higher rate; but the holdings of the Fed roll over and then earn that higher rate, and the Fed then remits the higher-rate receipts to the US Treasury.
I admit that by now I must have lost half my readers. For those still with me, I will copy below the actual language from the CBO report. For me, the bottom line is this: we have an analysis that assumes no material Fed balance sheet changes, while we know that is one thing we surely should not assume. And we have a warning from the Richmond Fed to be thinking about the federal bailout safety net, which is just as large now as ever.
All this is occurring in the United States while much of the rest of the world is engaged in extreme QE, following on the heels of our own QE process. They are a few years behind us. And with all that QE, we still have low global inflation and slow growth.
So, I’m a terrified bull but still bullish. Enduring low interest rates mean higher asset prices. The transfer of stimulus from higher asset prices to more economic growth is a slow one and takes years.
So, it seems that we have more time. That said, my fear is that all this will end badly once we do get to the ending. I still think that will be from an S&P 500 Index level above 3000 and will come after the end of this decade.
Excerpt from CBO follows:
If interest rates on all types of Treasury securities were 1 percentage point higher each year through 2025 than projected in the baseline and all other economic variables were unchanged, the government’s interest costs would be substantially larger. The difference would amount to only $12 billion in 2015 because most marketable government debt is in the form of securities that have maturities greater than one year. As the Treasury replaced maturing securities, however, the budgetary effects of higher interest rates would mount, climbing to an additional $198 billion in 2025 under this scenario.
As part of its conduct of monetary policy, the Federal Reserve buys and sells Treasury securities and other securities, including, over the past few years, a large amount of mortgage-backed securities. The Federal Reserve also pays interest on reserves (deposits that banks hold at the central bank). The interest that the Federal Reserve earns on its portfolio of securities and the interest that it pays on reserves affect its remittances to the Treasury, which are counted as revenues. If all interest rates were 1 percentage point higher for the coming decade than CBO projects, the Federal Reserve’s remittances would be lower for a number of years because higher interest payments on reserves would outstrip additional interest earnings on its portfolio. However, over time, the current holdings in the portfolio would mature and be replaced with higher yielding investments; CBO projects that by 2023 the Federal Reserve’s remittances would be higher if projected interest rates were higher. Overall, rates that were 1 percentage point higher than in CBO’s baseline would (holding all else equal) cause revenues to be $93 billion lower between 2016 and 2025.
The larger deficits generated by the increase in interest rates would require the Treasury to borrow more than is projected in the baseline. That extra borrowing would raise the cost of servicing the debt by amounts that would reach $79 billion in 2025. All told, if interest rates were 1 percentage point higher than projected in CBO’s baseline, the deficit would worsen progressively over the projection period by amounts increasing from $35 billion in 2015 to $272 billion in 2025. The cumulative deficit would be $1.7 trillion higher over the 2016–2025 period.
Related podcast interview:
Dr. Lacy Hunt on the Six Characteristics of Over-Indebted Economies
