By: Phil Kernen
For the last decade, the Federal Reserve has been the biggest bond buyer in the U.S. Treasury and Mortgage-Backed Bond markets, expanding its balance sheet from about $800 million to more than $8 trillion. So long as inflation remained low, their actions produced a slowly growing economy by keeping interest rates and unemployment low. Now that inflation is at its highest level in forty years, and the Federal Reserve is starting to raise interest rates in response, the financial condition of the Federal Reserve could get ugly.
SOMA, an acronym for System Open Market Account, is used by the Federal Reserve for all its open market operations, including purchasing and selling domestic securities and foreign currency. Every bond purchased goes into the SOMA. Unlike public (and many private) businesses, including banks it regulates, the Federal Reserve does not follow Generally Accepted Accounting Principles (GAAP). The Fed follows its own rules to defer any unrealized gains or losses until selling securities.
As the SOMA grows and interest rates fluctuate, the value of those same bonds will also fluctuate. After 2008, interest rates generally followed a downward trend that started in the 1980s; the unrealized gain in SOMA bonds was positive, reaching $400 billion in 2020. However, two short periods of rising rates in 2013 and 2018 led to net unrealized losses of approximately $60 billion at the Fed. It closed out 2021 with an unrealized gain of $128 billion.
Now we find ourselves with inflation at the highest levels seen in forty years, and the Federal Reserve is planning to raise rates aggressively. Financial markets have already done much of the heavy lifting, decreasing equity prices and moving the 10yr U.S. Treasury from 1.5% to more than 3.0%. Current estimates suggest net unrealized losses could exceed $500 billion.
Following the accounting rules adopted by the Fed, these unrealized losses will only appear on supplemental disclosures; they will never post them to the balance sheet. However, as they grow more significant, two problems will arise. The first is political as members of Congress realize that the Federal Reserve is sitting on assets worth less than their purchase price to the tune of $500 billion or more. The number will grow as rates continue to rise.
The second problem is more practical. The Fed wishes to sell precisely zero of these bonds, preferring to reduce its balance sheet by allowing bonds to mature without reinvesting the proceeds. Yet the odds are growing that simply raising rates will not be enough to arrest inflation to the desired degree. Reducing the SOMA account balance will be required, necessitating some sales and realized losses. If those losses are significant enough, it could reduce or eliminate remittances to the Treasury that have exceeded more than $100 billion in some years.
The Fed may have adopted accounting standards to manage its unique congressionally created organization. But if inflation pressures force them to start selling off their assets, they won’t be able to ignore the resulting losses for long, further hindering their flexibility to provide future monetary accommodation.
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