The Liberty Street Economics Blog over at the NY Fed continues their series on the System Open Market Account (SOMA). We really liked “More Than Meets the Eye: Some Fiscal Implications of Monetary Policy”, published on August 15th and written by Marco Del Negro, Jamie McAndrews, and Julie Remache. SOMA has made a lot of money for the Fed (and by extension the taxpayers), but that may not last.
Is the Fed trying to raise the flag and warn us? It certainly seems that way. In 2012 the Federal Reserve paid the Treasury $88.4 bio. Most of this came from the profits they made on SOMA. The Fed is playing the borrow short / lend long game and is making a lot of carry. As securities financing people, it is ironic to us that the games played by, well, almost every Wall Street firm that went bust since Drysdale (not to mention those who didn’t hit the wall) are being replicated by the Fed. They recognize that the exercise is a massive maturity transformation trade and, with rising interest rates, it might go away – or worse – start to lose money.
From the blog post,
“…an LSAP [large-scale asset purchase] swaps long-term for short-term government debt…”
and
“…An LSAP that swaps long-term for short-term debt leaves the government, and therefore ultimately the taxpayer, exposed to a different interest rate risk profile, so that when rates go down, it may lower government financing costs—as measured by coupon and interest payments on debt—and vice versa when rates go up… “
Putting the $88.4 bio that the Fed sent the Treasury in 2012 into context, for the first ten months of fiscal 2013 the Federal budget deficit has been $607.4 bio with a Congressional Budget Office projection of $670 bio for this fiscal year. Fiscal 2013 will probably be a good year for the SOMA, albeit dented by upticks in interest rates. Since the Fed does not pay interest on currency they issue, there is a built-in source of portfolio carry. This is called “seigniorage” – there, you learned something today. But the Fed does pay interest on excess reserves (25bp). When short term interest rates do end up rising, and the Fed increases the rate they pay on reserves, their portfolio will take a hit on carry (to say nothing of mark to market losses on the asset side). Should there be a substantial drop in SOMA driven remittances, it will create a big hole to fill on the deficit. Be careful what you wish for.
The Liberty Street Economics blog noted several other knock-on effects on the economy.
“…Monetary policy affects economic activity, with implications for both revenues (for example, via tax collection) and expenditures (for example, because of automatic stabilizers).
Monetary policy affects Treasury borrowing costs. This is true not only when the Fed changes interest rates with “conventional” monetary policy, but also when it changes rates with “unconventional” monetary policy (for example, LSAPs) via an effect on risk premia (see Gagnon, Raskin, Remache, and Sack).
Monetary policy affects inflation. U.S. government debt is mostly nominal, which implies that changes in inflation affect the real cost of financing the debt…”
We suspect that increased economic activity is up there on the Fed’s Christmas wish list, but higher interest rates and inflation, probably not so much.
Watching for SOMA revenue surprises won’t be very high up on the most radar screens – but with the Fed banging the drum – it probably should be.
A link to the NY Fed Liberty Street Economics blog post is here.
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One additional point on the Fed’s SOMA holdings; Operation Twist has pushed the bulk of the Fed’s holdings into the 2016 to 2020 segment of the curve. While under normal circumstances the Fed’s holding would ‘roll off’ steadily over time the current mix of Treasuries will have to be sold or repoed back into the market as rates rise in order to unwind the Fed’s Quantitative Easing. In addition, the Fed’s MBS holdings will demonstrate an increase in duration as rates rise and therefore further complicate the Fed’s ability to unwind its current program.