Federal Reserve losses in the next years are unlikely, Chairwoman Janet Yellen said Wednesday in testimony downplaying what Fed experts see as a major political risk facing the central bank over the next few years.
Although the Fed is paying banks interest on $2.3 trillion of reserves held at the central bank, “it is very unlikely that the Fed would end up with negative income,” Yellen said during a House Financial Services Committee hearing.
Experts have suggested that the Fed could face losses in hundreds of billions of dollars over several years, depending on how quickly it raised rates and the strength of the economy.
The Fed would be able to manage those losses without having its monetary policy operations disrupted. But the upshot would mean that the Fed would not reimburse the Treasury for a period of time and that it would risk confusion about why it was paying banks for excess reserves at the same time it was raising rates.
Yellen, however, discounted that scenario, calling it “conceivable” but unlikely. The situation in which the Fed may face losses, she said, would be if the economy took off and the Fed was forced to raise interest rates faster than expected, entailing larger payments to banks for excess reserves.
But that scenario, she said, “would be a very nice situation for the United States to find itself in,” given that the economy would be booming and tax revenue flowing into the Treasury.
In a more normal scenario, the Fed would raise interest rates only to a certain level before beginning to wind down its swollen $4.5 trillion balance sheet. Reducing its massive holdings of bonds and reducing excess reserves would lower potential losses.
The flip side of potential losses is the fact that the Fed has sent extra-large sums, in the hundreds of billions, to the Treasury in recent years. Rep. Brad Sherman, D-Calif., thanked her for the payments later in Wednesday’s hearing.
“We’re pleased to be able to turn over $100 billion checks, but that is not what drives policy,” Yellen said.
“Speaking on behalf of the Congress that would otherwise have to cut cancer research or cut school lunches, thank you for the $100 billion checks,” Sherman responded.
The Fed has been paying banks interest on excess reserves since 2008, currently paying a 0.5 percent rate.
Although many other countries use payments on excess reserves as a monetary policy tool, it’s a new tool for the Fed. Yellen and company have leaned on it in beginning to raise rates because the short-term interest rate it has targeted in the past, the fed funds rate, has become more difficult to manage in the wake of the financial crisis. That market involves banks trading funds to meet overnight reserve requirements, but there is little need for banks to do so when they have trillions of dollars in excess reserves.
