Now that there is growing evidence of GDP growth, we must consider a new topic: the likely effect on central bank balance sheets, using the US Fed as an example.
Since the banking crisis the Fed has acquired substantial quantities of securities as a result of the assistance it gave to too-big-to-fail banks and subsequently through quantitative easing, most of the assistance to the banks, the Maiden Lane and TALF securitisations, has been repaid. But since then, QE has swelled the Fed’s balance sheet to $3.6 trillion. The financing of this expansion is reflected mainly in excess reserves, which are deposits in favour of depository institutions, in excess of their required reserves.
As bond yields rise, it is obvious that the Fed will have to absorb portfolio losses, currently amounting to about $20bn for each one per cent fall in the value of its US Treasuries and $13bn on its mortgage securities (though these are likely to be more stable in price due to their self-liquidating nature). So far, 10-year Treasuries have fallen about 12% since end-April, and the Fed has $522bn of Treasuries with a maturity of over 10 years. In very rough terms the losses on its Treasuries of all maturities are likely to be about $200bn since April, larger than the Fed’s own capital by a very wide margin.
On the face of it, it doesn’t matter if the Fed’s capital is wiped out because it can easily magic up some more. But another problem will come when it has to raise interest rates: what will it do to stop banks withdrawing their excess reserve deposits? Presumably raise the interest rate paid on them. But it will probably appear to the wider public that the Fed is paying the banks not to lend money to businesses and people. At the moment interest on reserve deposits is only ¼%, but what if it has to be raised to 3% or 4% or even more to control bank credit? The banks will be earning between them $60-80bn per annum by leaving their excess reserves at the Fed.
It can be seen that rising bond yields and interest rates will play havoc with central bank accounts. It wasn’t meant to be like this: economic recovery was going to allow the Fed to taper its QE, and government deficits would disappear as tax revenues recover, giving the space for the Fed to unwind its purchases of Treasury debt. Instead, rising interest rates are likely to make it very difficult for the Fed to reduce its holdings of Treasuries, eliminating all those inflationary excess reserves at the same time.
The other major central banks face the same problem, having expanded their balance sheets in the wake of the banking crisis. They will be expected to stabilise the banking system and ensure undercapitalised banks are not wiped out by rising bond yields, or wrong-footed by interest-rate swap exposures. If, at the same time, the central banks are forced to recapitalise themselves to appear solvent, one wonders what the effect will be on the currencies concerned.
We might be about to discover how sound they and their currencies really are.