If interest rates rise suddenly, the Fed could lose half a trillion dollars. That’s the difference in the December 31, 2012 value of the Fed’s portfolio and its projected value three years from now.
MSCI Inc. puts the dollar amount at $547 billion and includes the accompanying economic contraction and spike in inflation.
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It would be an unprecedented loss. Fed chair Ben Bernanke is scheduled to testify before Congress today on how the Fed would handle such a scenario.
What is the Fed’s exit plan from its current and unmatched stimulus program? Even if it is handled well, headlines could result in scrutiny from Congress. That’s something the Fed never gets excited about.
The trick is to balance the Fed’s quantitative easings (QE) with sufficient stimulus in the economy. Whether that can be sufficiently accomplished without inciting rampant inflation is still the key question.
The Fed does not mark its portfolio value to market. And if it holds the majority of its assets to maturity, the MSCI numbers would dwindle substantially.
The central bank cannot go bankrupt and it will not cease operations even if it has losses on its books.
How the Fed exits its QE programs will determine Bernanke’s legacy.
If the losses come simultaneously with high US budget deficits and a continued stalemate between the White House and Congress for putting the nation on a responsible fiscal path, it could raise the risks of inflation and cause long-term inflation expectations.
The current exit strategy is to sell the mortgage bonds after the Fed begins to raise rates. If those sales result in losses and the interest it pays to banks to fund its assets exceeds income, the Fed will record it as a deferred asset.