Is Stanley Fischer the Man To Successfully Manage Communication on the Fed's Future Losses?

On Thursday, March 13, the U.S. Senate confirmed the appointment of Stanley Fischer, former governor of the Bank of Israel, to the post of vice president of the American Federal Reserve (Fed).

A professor at the Massachusetts Institute of Technology (MIT) while also No. 2 at the International Monetary Fund (IMF) — and with former students including Ben Bernanke (former president of the Fed) and Mario Draghi (president of the European Central Bank) — Fischer’s qualities have received high praise in the media on numerous occasions.

What has received less media coverage is his successful tenure at the head of a central bank that had encountered serious financial loss problems over a long period of time. These are problems that the Fed will also have to deal with in the future following its exit from a quantitative easing (QE) program, and which, at present, have attracted little attention.

“Controversies”

As numerous economists have underlined, leaving QE will not happen without financial losses. Several options are available to the Fed.

It can choose to render unproductive the liquid assets injected via QE, by continuing to pay an interest rate on excess reserves equal to the key interest rate. Given that this key interest rate will most likely exceed the yield rates of the Treasury bills currently on the Fed’s balance sheet before said bills reach maturity (the Blue Chip Forecast, for example, anticipates a key rate of over 3 percent from 2017 onward), these operations will, de facto, be financial loss-makers for the Fed.

It can also sell back the long-term assets it purchased during the QE program. Given the increase in interest rates that generally goes hand in hand with a fall in bond prices, this is also synonymous with losses. If the minutes of the June 2011 Fed meeting are anything to go by, this option is particularly conceivable for mortgage-backed securities (MBS).

In a study released in August 2013, co-written by Frederic Mishkin, former member of the Fed’s Board of Governors, the authors anticipated that losses on the sale of MBS alone would reach 35 billion euros in 2018, under an “optimistic” scenario whereby asset purchases would cease in 2014.

Moreover, the authors point out that, in a context of high indebtedness, “a suspension of payments by the Fed to the Treasury over a significant period could mean that Fed decisions come under the more watchful eye of the general public, potentially leading to controversies that could threaten the institution’s independence.”

Accounting Manipulation

Is there cause for more concern? Contrary to the Israeli central bank, the Fed cannot have a negative capital account.

In fact, since January 2011, the Fed has adopted new accounting practices, whereby any losses will not be absorbed by the capital account, as is the case for all companies, but will show up as a negative liability on an account called “interest on Federal Reserve notes due to the U.S. Treasury.” The idea is that that the monetary institution’s future profits will, first of all, be used to reduce this item before being redistributed to the Treasury.

This accounting manipulation, which is rare but not solely limited to the Fed in the central banking world, is especially useful in the American context in that the Fed’s shareholders are not the state but private banks (it must be pointed out that these shares do not accord the same rights as ordinary company shares).

In the event of substantial losses, this accounting practice could also mean that numerous debates on a subject that is often misunderstood and rarely broached — namely, the capital of the central banks — are avoided.

Credibility

Central banks can theoretically have low or negative capital without it affecting their policy. It is the case of the Bank of Israel, whose negative capital is over 10 percent of its total assets, but historically it is not the case for all of the central banks having experienced this situation.

In practice, however, we can quite rightly ask how public opinion and the markets would react if they saw the Fed effectively disguising any negative capital. Although in the case of the Fed these fears are hard to justify from a purely theoretical point of view, it would be difficult to believe that its credibility would not be brought into question.

The problem of financial losses on the Fed’s balance sheet, albeit secondary, raises questions both in terms of political relations between the central bank and the Treasury and, more generally, in terms of the credibility of the monetary institution.

There is little doubt that Stanley Fischer, who was in fact able to push these problems into the background in order to carry out his presidency at the Bank of Israel with brio, will provide the Fed with good advice over the coming months.