PRIMER ON THE FEDERAL RESERVES BALANCE SHEET AND EARNINGS PROJECTIONS Jan 2013

7/29/2019 PRIMER ON THE FEDERAL RESERVES BALANCE SHEET AND EARNINGS PROJECTIONS Jan 2013

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Finance and Economics Discussion SeriesDivisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.

The Federal Reserves Balance Sheet and Earnings: A primer andprojections

Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, Daniel W.Quinn, and Alexander H. Boote

2013-01

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminarymaterials circulated to stimulate discussion and critical comment. The analysis and conclusions set forthare those of the authors and do not indicate concurrence by other members of the research staff or theBoard of Governors. References in publications to the Finance and Economics Discussion Series (other thanacknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.


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TheFederalReservesBalanceSheetandEarnings

Aprimerandprojections1

SethCarpenter,JaneIhrig,ElizabethKlee,DanielQuinn,andAlexanderBoote2

January2013

Abstract

Overthepastfewyears,theFederalReservesuseofunconventionalmonetarypolicy

toolshasledittoholdalargeportfolioofsecurities. Theassetpurchasesareintendedtoput

downwardpressureonlongerterminterestrates,butalsoaffecttheFederalReservesbalance

sheetandincome. WebeginwithaprimerontheFederalReservesbalancesheetandincome

statement. Then,wepresentaframeworkforprojectingFederalReserveassetsandliabilities

andincomethroughtime.

TheprojectionsarebasedonpubliceconomicforecastsandannouncedFederalOpen

MarketCommitteepolicyprinciples. Theprojectionsimplythatforthenextseveralyears,the

FederalReservesbalancesheetremainslargebyhistoricalstandards,andearningsremain

high. UsingtheFOMCsstatedexitstrategyprinciplesandtheBlueChipfinancialforecastsof

thefederalfundsrate,theprojectionshavetheFederalReservesportfoliobeginningto

contractin2015. Theportfolioreturnstoamorenormalsizeinearly2018or2019,andreturns

toamorenormalcompositionayearthereafter. TheprojectionsimplythatFederalReserve

remittancestotheTreasurywilllikelydeclineforatime,andinsomecasesfalltozero. Once

theportfolioisnormalized,however,earningsareprojectedtoreturntotheirlongruntrend.

Onnetovertheentireperiodofunconventionalmonetarypolicyactions,cumulativeearnings

arehigherthanwhattheylikelywouldhavebeenwithouttheFederalReserveassetpurchase

programs.Toillustratetheinterestratesensitivityoftheportfolioandearnings,weconsider

scenarioswhereinterestratesare100basispointshigheror100basispointslowerthaninthe

baselineprojections. Withhigherinterestrates,earningstendtofallabitmoreand

remittancestotheTreasurystopforalongerperiodthaninourbaselineprojections,whilewith

lowerinterestratesearningsareabitlargerandremittancescontinuethroughoutthe

projectionperiod. Witheitherinterestratepath,earningsfollowthesamegeneralcontouras

inthebaselineanalysis.

1ThispaperisanexpansionoftheTheFederalReservesBalanceSheet: APrimerandProjections,FEDSWorking

Paper#201256.2TheauthorsarestaffeconomistsandresearchassistantsintheDivisionofMonetaryAffairs,BoardofGovernors

oftheFederalReserveSystem,Washington,D.C.20551U.S.A. WethankJamesClouse,BillEnglish,MichelleEzer,

DonHammond,LawrenceMize,JulieRemache,ViktorsStebunovs,LisaStowe,JeffMoore,AriMorse,andBrett

Schulteforthoughtfuldiscussionsandassistance. Theviewsinthispaperaresolelytheresponsibilityofthe

authorsandshouldnotbeinterpretedasreflectingtheviewsoftheBoardofGovernorsoftheFederalReserve

SystemorofanyotherpersonassociatedwiththeFederalReserveSystem.


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1 IntroductionInresponsetothefinancialcrisisthatbeganin2007andthesubsequentrecession,theFederal

Reservehasbeenemployingavarietyofnontraditionalmonetarypolicytools. Theuseofthese

toolshassignificantlyaffectedthesizeandcompositionoftheFederalReservesbalancesheet,

aswellasitsearnings.3 TheFederalReservesactionshavegarneredpublicattention,and

FederalOpenMarketCommittee(FOMC)membershaveoftendiscussedinspeechesandpublic

forumshowtheiractionshaveinfluencedthesizeofthebalancesheet. Theexpansionofthe

balancesheethasalsopromptedquestionsabouttheinterestrateriskoftheportfolio. Using

publicallyavailabledataandFederalReserveBankaccountingconventions,weprojectthe

FederalReservesbalancesheetandincomethrough2025. Theprojectionsincludealternate

scenariosformonetarypolicyin2013andaroughgaugeoftheinterestrateriskoftheFederal

Reservesbalancesheet.

AsshowninFigure1,through2007,thelargestassetitemoftheFederalReserve(reported

abovethehorizontalaxis)wasTreasurysecurities. Thelargestliabilityitem(reportedbelow

thehorizontalaxis)wasFederalReservenotesthatis,currency. Priortothefinancialcrisis,

theFederalReservesbalancesheetgrewatafairlymoderatepace,withtheOpenMarketDesk

(Desk)attheFederalReserveBankofNewYorkpurchasingadditionalTreasurysecurities

roughlyonpacewiththeexpansionofcurrencyandFederalReserveBankcapital.

Atthestartofthefinancialcrisis,theFederalReservesbalancesheetbegantoexpandata

fasterpace,largelybecauseofanincreaseoflendingthroughtheliquidityandcreditfacilities

thatwereestablishedatthattime.4 Theseextensionsofcreditexpandedtheassetsideofthe

balancesheet,whileasubstantialportionofthematchingincreaseontheliabilitysideofthe

3 TheFederalReservesbalancesheetispublishedeachThursdayintheH.4.1statisticalrelease,availableat

http://www.federalreserve.gov/releases/h41/. TheFederalReservesincomestatementisfoundintheFederal

Reserves AnnualReportavailableathttp://www.federalreserve.gov/publications/annualreport/default.htm.4ForadiscussionoftheFederalReservescreditandliquidityfacilities,see

http://www.federalreserve.gov/monetarypolicy/bst.htm.


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balancesheetwasinreservebalances.5 Theseliquidityfacilitiesbegantowinddownasthe

FederalReservesassetpurchaseprogramsstartedtorampup. Asaconsequenceoftheasset

programs,theFederalReservesSystemOpenMarketAccount(SOMA)portfoliothatis,its

holdingsofsecuritiesmorethantripledfrom2008totoday,andinDecember2012exceeded

$2.6trillion.

AssociatedwiththesubstantialchangeintheFederalReservesbalancesheethasbeena

notablechangeintheFederalReservesnetearnings. TheFederalReservegeneratesa

substantialportionofitsincomefromtheinterestearningassetsheldbytheFederalReserve

Banks,particularlyintheSOMAportfolio. FederalReserveexpensesincludeoperating

expensesnecessarytocarryoutitsresponsibilities,aswellasinterestexpenserelatedto

certainliabilitiesoftheFederalReserveBanks;currently,thelargestinterestexpensestems

fromreservebalances. FederalReserveincome,lessexpenses,plusprofitandlossonsalesof

securities,isreferredtoasnetincome. TheFOMCpursuesitsstatutorilymandatedgoalsof

fullemploymentandstableprices,andtheresultingnetincomeissimplyabyproductofthe

actionstaken. TheFederalReserveisstatutorilyrequiredtopaydividendsoncapitalpaidin.

UnderBoardofGovernorspolicy,afterretainingsufficientearningstoequatesurpluscapitalto

capitalpaidin,theFederalReserveBanksremitresidualnetincometotheU.S.Treasury.

AsaresultoftheFOMCsactionstoachieveitsmonetarypolicygoals,theFederalReserve

recentlyhasbeenremittingmoreincometotheTreasurythanwashistoricallythecase. As

showninFigure2,interestincomehasincreasednotably,particularlytheportionattributable

totheSOMAholdingsofagencyMBS. Moreover,interestincomehasrisensignificantlymore

thaninterestexpenseand,asaresult,remittancestotheTreasuryhavegrownsubstantiallyin

recentyears,fromroughly$25billionperyear,onaverage,from2001to2007,toalmost$80

billionin2010and2011,andtonearly$90billionin2012,asshowninFigure3. And,although

someattentionhasbeenfocusedonthechangeinthebalancesheetandthepotentialinterest

5Throughoutthispaperthephrasereservebalanceswillbeusedtodenotedepositsofdepositoryinstitutions

thatarenotintermdeposits. Thismeasureisreportedintables8and9oftheH.4.1statisticalreleaseas

Deposits,Otherdepositsheldbydepositoryinstitutions. Thisconceptisslightlydistinctfromtheconceptof

reservebalancesreportedintable1oftherelease. Thatconceptexcludes,amongotheritems,contractual

clearingbalances.


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rateriskthattheFederalReservehasincurred,infact,theFederalReservessecuritiesportfolio

currentlyhasanunrealizedgainpositionofroughly$249billionasofSeptember2012.6

ThispaperdescribesaframeworkforconstructingprojectionsoftheFederalReservesbalance

sheetandincomestatementunderavarietyofpossiblescenarios. Theseprojectionsarenot

forecasts. Aswillbecomeclear,theprojectionsdependcriticallyonawholehostof

assumptionsaboutfuturemonetarypolicydecisions,financialmarketdevelopments,andother

issues. Theassumptionsandprojectionsofeachofthosefactorsimplyapathforthebalance

sheetandremittancestotheTreasury. Theseprojectionsillustratehowthevariousfactorsthat

affectthebalancesheetandincomeoftheFederalReservedosodynamically. Ofcourse,other

assumptionsareplausible,andtheaimofthispaperistoillustratehowonecouldtakevarious

assumptionstocreateprojections.

Webaseourmodelingonthreekeyinputs. First,westartwiththeFederalReservesbalance

sheetasofOctober31,2012andmodelassetprogramsannouncedthroughDecember2012.

Inparticular,theFOMCsDecember2012statementindicatedthat:

Tosupportastrongereconomicrecoveryandtohelpensurethatinflation,overtime,

isattheratemostconsistentwithitsdualmandate,theCommitteewillcontinue

purchasingadditionalagencymortgagebackedsecuritiesatapaceof$40billionper

month. TheCommitteealsowillpurchaselongertermTreasurysecuritiesafteritsprogramtoextendtheaveragematurityofitsholdingsofTreasurysecuritiesis

completedattheendoftheyear,initiallyatapaceof$45billionpermonth.[]The

Committeewillcloselymonitorincominginformationoneconomicandfinancial

developmentsincomingmonths. Iftheoutlookforthelabormarketdoesnotimprove

substantially,theCommitteewillcontinueitspurchasesofTreasuryandagency

mortgagebackedsecurities,andemployitsotherpolicytoolsasappropriate,untilsuch

improvementisachievedinacontextofpricestability.

Theprogramoutlinedinthisstatementishighlyconditionalonmacroeconomicoutcomes.

Modelingthejointmacroeconomicandmonetarypolicyinteractionsisoutsidethescopeofthe

presentpaper. However,weconsiderthebalancesheetandincomeeffectsofthreealternative

additionalassetpurchaseamounts: noadditionalpurchases;$500billioninadditional

6ThequarterendmarketvalueoftheSOMAportfolioispublishedintheFederalReserveBanksCombined

QuarterlyFinancialReports,availableathttp://www.federalreserve.gov/monetarypolicy/bst_fedfinancials.htm#quarterly.


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purchasesin2013atapaceof$45billionpermonthofTreasurysecuritiesand$40billionper

monthofagencyMBS;and$1trillioninadditionalpurchasesin2013atapaceof$45billionper

monthofTreasurysecuritiesand$40billionpermonthofagencyMBS. BecausetheFederal

Reservehaspurchasedsecuritiesin2013,thefirstscenarioisnotpossible,butitnevertheless

providesagoodbenchmarkforcomparingtheoutcomesofthedifferentscenarios.

Second,weinterprettheminutesoftheJune2011FOMCmeetingtoputsomestructureona

plausibleexitstrategyfrommonetarypolicyaccommodation. Theseexitprinciplessuggesta

sequenceofmonetarypolicyactions,startingwithallowingSOMAholdingstomatureandroll

offtheportfolio. Inourprojections,weassumethisisthefirststeptoexitthecurrent

unconventionalmonetarypolicyaccommodation. ThenweassumethattheFOMCbeginsto

raisethetargetfederalfundsrate,andfinallyitsellsSOMAassets,inordertonormalizethe

sizeandcompositionofthebalancesheetwithinanumberofyears.

Finally,werelyontheDecember2012BlueChipEconomicIndicatorsforecastfornominalGDP

growthandinterestrates. TheBlueChipEconomicIndicatorsisaconsensusforecastbasedon

asurveyofprofessionalforecasters;weusethemeanoftheforecastforourselectedeconomic

variablesforguidancewiththeirprojectedpaths. Weassumethatthetimingofthevarious

elementsoftheexitstrategyistiedtothetimingoftheliftoffofthefederalfundsrate. Allof

theseinputsarepubliclyavailableandinnowayrepresentaforecastfromtheFederalReserve

oritsstaff.

Keyfindingsusingtheassumptionsnotedabovearethefollowing. First,theprojectionsyielda

FederalReservebalancesheetthatremainslargebyhistoricalstandardsforanumberofyears.

Inparticular,theSOMAportfolioexpandswithassetpurchasesin2013andthencontractsat

onlyaslowpacethroughthemediumterm,reflectingthefactthatasofDecember2012,the

FOMCsuggestedthatconditionswillmostlikelywarrantkeepingthefederalfundsrateat

exceptionallylowlevelsforsometime.7 Undertheassumptionofnofurtherassetpurchasesin

7TheDecember2012FOMCstatementexplicitlystatedthattheCommitteedecidedtokeepthetargetrangefor

thefederalfundsrateat0to1/4percentandcurrentlyanticipatesthatthisexceptionallylowrangeforthefederal

fundsratewillbeappropriateatleastaslongastheunemploymentrateremainsabove61/2percent,inflation

betweenoneandtwoyearsaheadisprojectedtobenomorethanahalfpercentagepointabovetheCommittees


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2013,theSOMAportfoliodoesnotreturntoamorenormalsizeuntilearly2018. Underthe

assumptionofanadditional$1trillioninassetpurchasesin2013,theportfolioreturnstoa

morenormalsizeinearly2019. Ineithercase,thecompositionoftheportfoliodoesnotreturn

tonormaluntilaboutayearafterthesizenormalizes.

Second,theprojectionsimplythatremittancestotheTreasurycontinueatarobustpace

through2015. However,whenthefederalfundsrateincreasesandsecuritiessalescommence,

remittancesmightbehaltedforafewyears,reflectingtheelevatedinterestexpenseonreserve

balancesandcapitallossesassociatedwithsalesofMBS,bothofwhichoffsettheinterest

incomefromtheportfolio. FederalReserveBankaccountingrulesstipulatethatwhenincome

isnotsufficienttocoverexpenses,remittancestotheTreasurycease,andtheFederalReserve

booksadeferredasset.8 Inthescenariowithnoadditionalpurchasesin2013,theprojection

suggestsalowlevelofremittancesforafewyears,butnodeferredasset. However,larger

amountsofsecuritiespurchasedin2013increasethelikelihoodofadeferredasset. The

projectionwith$1trillionofadditionalpurchaseshasadeferredassetforabout4years,witha

peakvalueof$45billion. Itisimportanttonotethatadeferredassetwouldnothaveany

implicationsfortheFOMCsabilitytoconductmonetarypolicy,butremittancestotheTreasury

wouldhalt. Thatsaid,projectionsforcumulativeremittancesfrom2009and2025are

projectedtobeatleast$720billion,orover$40billionperyear,substantiallymorethanthe

roughly$25billionperyearremittedpriortothefinancialcrisis. Thislongerrunperspectiveon

remittancesisimportant,becausetheremittancesfluctuatesubstantiallyfromyeartoyearin

ourprojections,withearningsbeingelevatedintheneartermandfallinglaterasassetsales

incursomerealizedcapitallossesandinterestexpenserisestemporarily. Attheendofthe

projectionperiod,whentheSOMAportfoliogrowsatitslongruntrend,remittancestothe

2percentlongerrungoal,andlongerterminflationexpectationscontinuetobewellanchored. Moreover,the

statementalsoindicatedthatthesethresholdswereconsistentwiththeearlierdatebasedguidancethat

suggestedthatexceptionallylowlevelsofthefederalfundsratewerelikelytobewarrantedatleastthroughmid

2015.8ThedeferredassetissubsequentlyrealizedasareductionoffutureremittancestotheTreasury(whichare

accountedforasinterestonFederalReservenotesexpense).Thus,itisanassetinthesensethatitembodiesa

futureeconomicbenefitthatwillberealizedasareductionoffuturecashoutflows.Iftherealizationoftheassetis

expectedtooccuroverseveralyears,somevaluationtechnique,suchasnetpresentvalue,wouldbeappliedto

measurethevalueoftheasset.ThisaccountingtreatmentisconsistentwithU.S.GAAPandissimilartotheway

thatprivatecompaniesreportdeferredlosscarryforwardsasanasset.


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Treasuryareabout$45billionperyear. Morebroadly,theintentoftheassetpurchasesisto

stimulateeconomicactivityandhelptheFederalReservetofosteritsdualobjectivesof

maximumemploymentandstableprices. Chungetal.(2011)providesomeestimatesofthe

macroeconomiceffectoftheassetpurchases,whichwouldlikelyresultinhighertaxrevenue,

andthiseffectwouldlikelybesubstantiallylargerthananyfluctuationinremittancesbythe

FederalReserve.

Third,FederalReserveearningsandremittancestotheTreasuryexhibitsensitivitytothe

forecastforinterestrates. Toillustratetheseriskstotheprojections,weconsiderascenario

wherebothshorttermandlongerterminterestratesare100basispointshigherthaninthe

baselineprojection. Relativetothebaselineprojections,underthisassumption,remittancesto

theTreasuryceasefor2to3additionalyears,andthedeferredassetspeakatlargeramounts.

Inessence,highershortterminterestratesmakeinterestonreservesmorecostly,andhigher

longterminterestratesmakesellingMBSmorecostly. Wealsoconsiderascenariowhere

ratesare100basispointslowerthaninthebaselineprojection. Thelowerratesdampen

realizedlossesandinterestexpense,andasaresult,theFederalReserveremitsearningstothe

Treasurythroughouttheprojectionandnodeferredassetisrecorded. Underanyofthe

interestratepathsstudiedhere,however,onnet,theFederalReservesnontraditionalpolicy

tendstoboostremittancestotheTreasuryovertheprojectionperiodinitsentirety.

Thepaperisorganizedasfollows. Section2providesaprimerontheFederalReservesbalance

sheetandaccounting,includingtheSOMAportfolioandtheFederalReservesincome

statement. Section3outlinestheassumptionsusedasinputstotheprojectionsofthebalance

sheet. ThebalancesheetandincomeprojectionsarediscussedinSection4,boththe

projectionsforthethreepurchaseoptionsunderthebaselineassumptionforinterestrates,

andthesameprojectionswithinterestrateshocksthatillustratetheinterestratesensitivityof

theportfolio. Section5concludes. Twoappendixesarealsoincluded. Appendix1provides

moredetailontheassumptionsunderlyingtheprojections. Appendix2describesthemethod

usedtoderiveprojectionsoffuturevaluationsandincomefromSOMAsecurities.


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2 TheFederalReservesbalancesheet,incomestatement,andvaluationoftheSOMAportfolio

Inthissection,wereviewkeybalancesheetcomponentsinourprojections,aswellasthe

incomegeneratedfromthebalancesheet. Wealsoprovidesomehistoricalcontextforthe

evolutionoftheseitems. DiscussionofotherassetsandliabilitiescanbefoundinAppendix1.

2.1 TheFederalReservesbalancesheetOurdiscussionoftheFederalReservesbalancesheetwillrefertotheconsolidatedbalance

sheetsofthe12individualReserveBankbalancesheets.9 Inreality,theaccountingthatwillbe

discussedbelowisdoneattheReserveBanklevel;however,forsimplicity,wefocusonthe

FederalReserveSystemsaggregatebalancesheet.

Likeanybalancesheet,theFederalReservehasassetsononesideofthebalancesheet,which

mustequalliabilitiespluscapitalontheotherside. AsshowninTable1,attheendof2006,

totalassetsoftheFederalReservewere$875billion,withthesinglelargestassetitembeing

theSOMAportfolio,atabout$780billion. Priortothefinancialcrisis,thedomesticSOMA

portfoliocomprisedonlyTreasurysecurities,ofwhichroughlyonethirdwereTreasurybillsand

twothirdswereTreasurycouponsecurities. Ontheothersideofthebalancesheet,thelargest

liabilityitemwaspapercurrency,orFederalReserveNotes(FRNotes),atabout$785billion.

Withthelendingthattookplaceduringthefinancialcrisis,foratime,lendingofvarioussorts

surpassedthesizeoftheSOMAportfolio. AsofDecember26,2012,however,theSOMA

portfoliowasagainthelargestassetitem,andithadgrownto$2.6trillionbecauseoftheasset

purchaseprograms. Ontheliabilitysideofthebalancesheet,FRNotes,atabout$1.1trillion,

werenolongerthelargestliabilityitem. Instead,astheFOMCincreaseditsassetpurchases,

reservebalancesincreasedcorrespondinglytoalevelabout$1.5trillion.

9TheBoardofGovernorsdoesnotholdassetsandliabilitiesinthesamewaythattheReserveBanksdo. Section

10oftheFederalReserveActauthorizestheBoardtolevysemiannuallyupontheReserveBanks,inproportionto

theircapitalstockandsurplus,anassessmentsufficienttopayitsestimatedexpensesforthehalfoftheyear

succeedingthelevyingofsuchassessment,togetherwithanydeficitcarriedforwardfromtheprecedinghalfyear.


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Table1:FederalReserve'sBalanceSheet,end2006andpresent

Source:H.4.1StatisticalRelease

ThenextfewsubsectionsreviewthekeycomponentsoftheFederalReservesbalancesheet

andhowtheyhavechanged.10

2.1.1 TheSOMAportfolio:Composition,size,andmaturitystructureOvermostofthepostwarperiod,theSOMAportfoliowasthelargestassetitemontheFederal

Reservesbalancesheet.11 Duringthattime,theSOMAportfolioessentiallyheldTreasury

securities;however,theportfoliohasheldothertypesofsecuritiesinitsportfoliooverits

history.12 Forexample,from1971to1981,theFederalReservepurchasedlimitedquantitiesof

agencysecurities;thelastofthesesecuritiesmaturedintheearly2000s,andnonewas

purchaseduntil2008.13

Historically,thesizeoftheSOMAportfolioandthebalancesheetmoregenerallyreflected

growthinFRNotesandReserveBankcapital. Whencurrencyisputintocirculation,itis

shippedtoadepositoryinstitutionandthatinstitutionsaccountattheFederalReserveis

debitedbyanequivalentamount. Becausecurrencyoutstandingtendstotrendupward,over

timecurrencygrowthwouldtendtoreducetheamountofreservebalancesinthebanking

system. TheFederalReservewouldpurchasesecuritiesinopenmarketoperationstooffsetthis

drainofreserves. Onnet,therefore,thegrowthrateofcurrencytendedtodrivethesizeofthe

10Foradescriptionofadditionalcomponentsofthebalancesheet,seetheinteractiveguidestotheH.4.1tablesat

http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm,ortheFinancialAccountingManualat

http://www.federalreserve.gov/monetarypolicy/files/bstfinaccountingmanual.pdf.11ForadescriptionoftheFederalReservesbalancesheetpriortoWorldWarII,seeBankingandMonetary

Statistics,19141941(1943).12RefertoEdwards(1997).

13RefertoMeltzer(2010).

SOMA 779

Depositsof

DIs 13

SOMA 2,661

Deposits

of

DIs 1,533

Otherassets 95 FRnotes 783 Otherassets 248 FRnotes 1,125

Otherliabilities 49 Otherliabilities 198

memo:Capital 31 memo:Capital 55

Assets Liabilities Assets Liabilities

Balancesheetend2006 BalancesheetDecember26,2012

billionsof$ billionsof$


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balancesheet. Similarly,whenadepositoryinstitutionisrequiredtosubscribetoalarger

amountofFederalReservecapitalortheFederalReserveaddstoitssurplusaccount,theresult

wouldbeallelseequalareductioninreservebalances.14 Asaresult,theSOMAportfolio

mustincreasetooffsettheseincreasesaswell,creatingalargerbalancesheetoverall.

ThishistoricalpatternisillustratedinFigure4. Ascanbeseen,through2007,boththeSOMA

portfolioandcurrencyandcapitaltrendedupwardtogether. Whentheassetprogramsbegan

inlate2008andearly2009,andcontinuingthroughthesecondroundofpurchasesin2010and

2011,theSOMAportfolioincreasedmarkedlyandataratethatfaroutpacedthegrowthof

currencyandcapital. Withtheinitiationofthematurityextensionprogramin2011,thesizeof

theportfolioremainedroughlyconstant;however,asdepictedinFigure5,theweighted

averagematurityofTreasurysecuritiesintheSOMAportfolioincreasedmarkedly. Froma

longerperspective,overtime,theSOMAportfoliohashadarangeofmaturitiesofTreasury

securitiesinitsholdings.15 Priortothefinancialcrisis,theDesktendedtopurchasesecurities

acrosstheentireyieldcurvetoavoiddistortingtheyieldcurve. Butafterthestartofthe

financialcrisis,thematurityofTreasurycouponsecuritiesintheSOMAportfoliolengthened

notably,reflectingtherunoffinbillstosterilizethecreditandliquidityprogramsin2008,and

thepurchaseoflongerdatedsecuritiesmorerecently.

2.1.2 DepositsofdepositoryinstitutionsDepositsofdepositoryinstitutionsincludealldepositoryinstitutionsbalancesattheFederal

Reservethatareusedtosatisfyreserverequirementsandbalancesheldinexcessofbalance

requirements. Depositsofdepositoryinstitutionsgrewdramaticallythroughthecrisis,andare

currentlyquiteelevatedbyhistoricalstandards. Whenwerefertoreservebalances,weare

usingthedepositsofdepositoryinstitutionsconcept. Thesedepositsrepresentfundsthat

depositoryinstitutionsowntheyarealiabilityoftheReserveBank,butanassetofthe

depositoryinstitution. Thesefundsarealsousedforpaymentsystemsettlementforexample,

apaymentfromonebanktoanother(orfromonebankscustomertothecustomerofa

14Aswillbemorefullyexplainedlaterinthepaper,eachmemberbankofaReserveBankisrequiredtosubscribe

tothecapitalofitsdistrictReserveBankinanamountequalto6percentofitsowncapitalstock.15IntheweeklyH.4.1statisticalrelease,inadditiontotheFederalReservesbalancesheet,thematurity

distributionofassetholdingsisalsopublished.


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differentbank)typicallyresultsinadebittothepayingbanksaccountandacredittothe

receivingbanksaccount. Lendingofreservebalancesandpaymentactivityresultonlyina

movementofreservebalancesfromonedepositoryinstitutionsaccountattheFederalReserve

toanotherinstitutionsaccount;theaggregatequantityisunchanged.

2.1.3 FederalReserveNotesFederalReservenotes,orcurrency,arealiabilityoftheFederalReserve. Asapracticalmatter,

thequantityofcurrencyoutstandingisnotdeterminedbytheFederalReserve. Instead,when

adepositoryinstitutionwantstoholdcurrencyinitsvaultorautomatictellermachinesinorder

tomeetcustomerneeds,itrequestsashipmentfromitsFederalReserveBank. Whenthat

shipmentismade,thedepositoryinstitutionsreserveaccountattheReserveBankisdebited

bytheamountofthecurrencyshipment. OneimportantsourceofdemandforU.S.currencyis

fromoverseas. Althoughitisimpossibletoknowwithcertaintywhatportionofcurrency

outstandingisoutsideoftheUnitedStates,estimatessuggestthatthefractionisonehalfor

more.16 Priortothefinancialcrisis,currencywasthelargestliabilityitemontheFederal

Reservesbalancesheet.

2.1.4 Capitalpaidin,surplus,andinterestonFederalReservenotesduetoU.S.Treasury

ThecapitaloftheReserveBanksisdifferentthanthecapitalofotherinstitutions.17

Itdoesnot

representcontrollingownershipasitwouldforaprivatesectorfirm. Ownershipofthestockis

requiredbylaw,theReserveBanksarenotoperatedforprofit,andthestockmaynotbesold,

traded,orpledgedassecurityforaloan. AsstipulatedinSection5oftheFederalReserveAct,

eachmemberbankofaReserveBankisrequiredtosubscribetothecapitalofitsdistrict

ReserveBankinanamountequalto6percentofitsowncapitalstock. Ofthisamount,half

mustbepaidtotheFederalReserveBanks(referredtoascapitalpaidin)andhalfremains

subjecttocallbytheBoardofGovernors. Thiscapitalpaidinisarequiredassessmentonthe

memberbanksanditssizechangesdirectlywiththecapitalofthememberbanks. Also

16RefertoJudsonandPorter(1996).

17SeetheFinancialAccountingManualforFederalReserveBanks,whichreportstheaccountingstandardsthatshouldbefollowedbytheFederalReserveBanksat

www.federalreserve.gov/monetarypolicy/files/bstfinaccountingmanual.pdf, pageI68.


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stipulatedbylawisthatdividendsarepaidatarateof6percentperyear. Overthepast

decade,reflectingincreasesincapitalatmemberbanks,ReserveBankcapitalhasgrownatan

averagerateofalmost15percentperyear. Inaddition,ReserveBankshavesurpluscapital,

whichreflectswithheldearnings,andFederalReserveBankaccountingpoliciesstipulatethat

theReserveBankswithholdearningssufficienttoequatesurpluscapitaltocapitalpaidin. Asa

result,ascapitalofmemberbanksgrowsthroughtime,capitalpaidingrowsinproportion.

Becausesurplusissetequaltocapitalpaidin,itlikewisegrowsatthesamerateasmember

bankcapital.

Oneliabilityitemisdistinctfromtheothers. Asnotedabove,underitsremittancepolicythe

FederalReserveremitsallnetincometotheU.S.Treasury,afterexpensesanddividendsand

allowingforsurplustobeequatedtocapitalpaidin. Asthoseearningsaccrue,theyare

recordedontheFederalReservesbalancesheetasInterestonFederalReservenotesdueto

U.S.Treasury. Intheeventthatearningsonlyequaltheamountnecessarytocoveroperating

costs,paydividends,andequatesurplustocapitalpaidin,thisliabilityitemwouldfalltozero

becausetherearenoearningstoremitandthepaymenttotheTreasurywouldbesuspended.

Ifearningsareinsufficienttocoverthesecoststhatis,thereisanoperatinglossinsome

periodthennoremittanceismadeuntilearnings,throughtime,havebeensufficienttocover

thatloss. Thevalueoftheearningsthatneedtoberetainedtocoverthislossiscalleda

deferredassetandisbookedasanegativeliabilityontheFederalReservesbalancesheet

underthelineitemInterestonFederalReservenotesduetotheU.S.Treasury. Asdiscussed

aboveinfootnote8,itisanassetinthesensethatitreflectsareductionoffutureliabilitiesto

theU.S.Treasury.

OneconsequenceofthecurrentimplementationofFederalReserveBankaccountingpolicyis

thattherecordingofadeferredassetimpliesthatReserveBankcapitaldoesnotdeclineinthe

eventofanoperatingloss. Fromtimetotime,individualReserveBankshavereporteda

deferredasset;however,thesedeferredassetsweregenerallyshortlived.18 Ithasneverbeen

18Forexample,asshownontheH.4.1StatisticReleasefromNovember3,2011,theFederalReserveBankofNew

YorkrecordedalargeenoughdeferredassetsothattheFederalReserveSystemalsodid.


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12

thecasethattheFederalReserveSystemasawholehassuspendedremittancestothe

Treasuryforameaningfulperiodoftimebecauseofoperatinglosses.

2.2 TheFederalReservesincomestatementAstheFederalReservesbalancesheethasexpandedinrecentyears,theincomederivedfrom

thebalancesheethasalsogrown,thoughthekeylineitemsfromthebalancesheetthat

generatedthisincomearethesame. AsshowninTable2,netincomeinboth2006and2011

wasdrivenbyinterestincomefromtheSOMAportfolio. Despitethedifferenceinmagnitude,

inbothyears,SOMAinterestincomewasmorethan95percentoftotalincome. Thatsaid,

SOMAinterestincomegrewsubstantiallyoverthisperiodastheSOMAportfolioexpanded.

Interestexpense,ontheotherhand,wasminimalinbothyears. Inparticular,FRnotesarea

largeliabilitywithoutanassociatedinterestexpense. And,althoughtheFederalReservehas

paidinterestonreservebalancessinceOctober2008,thisliabilityitemhasincurredlittle

interestexpensebecausetheinterestonexcessreserves(IOER)ratehasbeenat25basispoints

sinceDecember2008. Inbothyears,otheritemsintheincomestatementweresimilar. In

total,remittancestotheTreasurywerepositiveinbothyears,butmuchlargerin2011because

oftheexpandedSOMAportfolio.

Table2:Incomeandexpenses,2006and2011

Source:FederalReserveAnnualReport

ThenextfewsubsectionsreviewthekeylineitemsoftheFederalReservesincomestatement

inmoredetail.

Interestincome 36.8 Interestexpense 1.3 Interestincome 84.5 Interestexpense 3.8

Otherincome 1.6 Otherexpense 3.7 Otherincome 0.7 Otherexpense 4.5

memo:Additions/deductions, 4.3 memo:Additions/deductions, 1.5

dividends, andtransfers dividends,andtransfers

Incomeandexpenses, 2006 Incomeandexpenses, 2011

billionsof$ billionsof$

Income Expense Income Expense


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2.2.1 SOMAinterestincomeAsnotedabove,incomeonthesecuritiesheldintheSOMAportfolioconstitutesthevast

majorityofinterestincome. SOMAinterestincomeprimarilyreflectsthesizeoftheportfolio

andtheweightedaveragecoupon(WAC)oftheportfolio,lessanyamortizednetpremiums

paidonsecurities.19 Asnotedabove,priortothefinancialcrisis,thesizeoftheportfolio

increasedsteadilyatamoderaterate. Withtheadoptionoftheassetprograms,thesecurities

portfolioexpandedrapidlyandnowstandsatalevelnoticeablyaboveitslongerruntrend. The

WAC,asshowninFigure6,fluctuatedovertime,risingandfallingwiththemarketratesand

theSOMAportfoliosholdings. ThispatternprimarilyreflectsthefactthattheFederalReserve

reinvestsmaturingTreasurysecuritiesatauction,andthecouponatauctiontendstobeinline

withmarketrates. Althoughtheassetpurchaseprogramsresultedinasignificantaccumulation

oflongertermdebtinrecentyears,muchofitwasissuedinalowinterestrateenvironment

and,therefore,theWACoftheportfoliodecreasedsomewhat.

PuttingthesizeoftheportfolioandtheWACoftheportfoliotogether,asshowninFigure7,

interestincomeclimbedatamoderatepaceintheyearspriortothefinancialcrisis,primarilyas

aresultofthesteadyincreaseinthesizeofSOMA,whichroseinlinewiththegrowthofFR

notesandcapital. Beginningin2009,interestincomefromtheportfoliorosenoticeablyas

largescaleassetpurchasesincreasedthesizeoftheportfolio.

2.2.2 InterestexpenseWiththeintroductionofinterestonreservesinthefallof2008andtheconcurrentriseinthe

levelofreservebalances,interestexpenserose. Asmentionedabove,theIOERratehasbeen

25basispointssinceDecember2008,andasaresult,evenwithasubstantialvolumeofreserve

balances,interestexpensefromreservebalanceshasbeenlowcomparedtointerestincome

andwasroughly$3.8billionin2011.

Inadditiontointerestexpensefromreservebalances,thereisalsointerestexpensefrom

reverserepurchaseagreements(RRPs),mostlygeneratedbytheforeignrepurchaseagreement

19SOMAinterestincomeisdefinedastherateofreturnontheportfolio(theproductofthesizeoftheportfolio

timestheWAC)minusamortizednetpremiums. Netpremiums,thoughimportantinderivingtheprecisevalueof

interestincome,willnotbeaprimarydriverofthecontouroftheprojectionsofinterestincome.


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(RP)pool.20,21

InterestratespaidontheforeignRPpoolaregenerallyinlinewithmarketrates,

andwhenreservebalancesarerelativelylow,interestexpenseontheforeignRPpoolcan

representalargeshareoftotalinterestexpense.

Reverserepurchaseagreementswithprimarydealersandotherinstitutionsandtheterm

depositfacility(TDF)alsohaveassociatedinterestexpense. Inadditiontotheprimarydealers,

theFederalReserveselectedmoneymarketmutualfunds,FederalHomeLoanMortgage

Corporation(FreddieMac),FederalNationalMortgageAssociation(FannieMae),andsome

banksaspotentialcounterpartiesforRRPs. BycontrasttotheRRPs,onlybanksarethe

counterpartiesinTDFtransactions. AlthoughtheFederalReservehasdevelopedthecapability

ofconductinglargescaleoperationsineithertheRRPsorTDF,neitherhasbeenusedina

materialsizetodate,andasaresult,interestexpenseassociatedwiththesefacilitieshasbeen

minimal.

2.2.3 Capitalgain(loss)UnderFederalReserveaccountingrules,aFederalReserveBankrealizesgainsorlossesona

securityonlywhenthesecurityissold. Atsale,wecalculatetheFederalReservesgainorloss

asthemarketvalueminustheparvalueandunamortizednetpremiumsonthesecurity.

Historically,theFederalReservedidnotgenerallysellsecurities,becausetheseculargrowthin

currencyresultedinaneedforalongtermincreaseinsecuritiesholdings. In2008,however,

theDeskdidsellsomesecuritiestooffsettheexpansionofthebalancesheetthatresultedfrom

theintroductionoftheliquidityfacilitiesattheearlystagesofthefinancialcrisis. Inthatyear,

theFederalReserverealizedacapitalgainofroughly$3billionbecausemarketrateshadfallen,

pushingupthemarketpriceofthesecuritiessold. Withthematurityextensionprogram,the

FederalReservehasalsosoldsecurities. In2011,thesesalesrealizeda$2.3billioncapitalgain.

20BeforeDecember13,2002,repotransactionswereconductedasmatchedsalespurchasetransactions,where

theFederalReservesoldasecuritywithanagreementtopurchaseitagainatalaterdate. However,because

matchedsalepurchasetransactionswereaccountedforasanoutrightsaleratherthanasafinancingtransaction

thewayreverserepurchaseagreementsare,thetransactionsdidnotresultininterestexpense.21EverybusinessdaytheFederalReserveconductsovernightreversereposwithforeigncentralbanksthathold

dollarsintheiraccountsattheFederalReserveBankofNewYork.Thesetransactionsareoneoftheservicesthat

centralbanksprovideoneanothertofacilitatetheirinternationaloperations.


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2.2.4 Paymentofdividends,transferstosurplus,andinterestonFederalReservenotesduetotheU.S.Treasury

Asnotedabove,memberbanksarerequiredtosubscribetothecapitalstockoftheReserve

Banks,andtheActstipulatesthattheFederalReservepaya6percentdividendonthiscapital.

UnderpolicyprescribedbytheBoardofGovernors,excessearningsareretainedassurplus

capitalinanamountequaltocapitalpaidin. BeforeremittancestotheTreasuryaremade

dividendsarepaidandearningsareretainedtoequatesurplustocapitalpaidin. Dividendsare

paidevenifremittancestotheTreasurywouldbezero. Asdiscussedearlier,intheeventthat

earningsfallshortoftheamountnecessarytocoveroperatingcosts,paydividends,andequate

surplustocapitalpaidin,theFederalReservebooksaliabilityofinterestonFederalReserve

notesduetoU.S.Treasury. ThislineitemisrecordedinlieuofreducingtheReserveBanks

surplus,andrepresentstheamountofearningstheFederalReserveneedstoaccumulate

beforeitresumesremittingresidualearningstoU.S.Treasury.

2.2.5 RemittancestotheTreasuryTheFederalReserveremitsanyearningsinexcessofoperatingexpensesanddividendstothe

Treasury.22 TheuseofthesefundsisstipulatedintheFederalReserveAct,whichstates:

ThenetearningsderivedbytheUnitedStatesfromFederalReservebanksshall,inthe

discretionoftheSecretary,beusedtosupplementthegoldreserveheldagainst

outstandingUnitedStatesnotes,orshallbeappliedtothereductionoftheoutstanding

bondedindebtednessoftheUnitedStatesunderregulationstobeprescribedbythe

SecretaryoftheTreasury.23

Overtime,asshownearlierinFigure3,remittancesremainedinarelativelysmallrange,

averagingabout$25billionintheyearsimmediatelyprecedingthefinancialcrisis. Duringthe

crisis,asFederalReserveincomeincreasednotably,sodidremittancestotheTreasury. Still,

remittancesremainedarelativelysmallshareofgovernmentreceiptsdwarfedbyindividual

incomeandcorporateincometaxes,asshowninFigure8,andaboutinlinewithcustoms

deposits(notshown).

22Occasionally,statutorytransfersoccur,whichmandatethattheFederalReservetransferaportionofitssurplus

totheTreasury. Thelasttimethisoccurredwasin2000,whenapproximately$3.8billionheldinthesurplus

accountwastransferredtotheTreasury.23FederalReserveAct,Section7,UseofEarningsTransferredtotheTreasury,12USC290,subsection(b).


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2.3 ValuationoftheSOMAportfolioThereareanumberofdifferentwaystorecordthevalueoftheSOMAportfolio. ReserveBank

accountingrecordstheSOMAportfolioatparvalue. Theparvalueoftheportfolio,reportedin

line1ofTable3,givesthefacevalueofthesecuritiesintheportfolio. Thisisthevalueofthe

portfolioreportedintheweeklyH.4.1statisticalrelease. Theamortizedcostoftheportfolio,

alsocalledthebookvalueoftheportfolioandshowninline3,istheparvalueoftheportfolio

plusanyunamortizednetpremiumsassociatedwiththesecurities. Athirdvaluationofthe

portfolioisthemarketvalue,line4. TheFederalReserveBanksCombinedQuarterlyFinancial

ReportsandtheAnnualReportalsoreportthefairvalue(essentiallythemarketvalue)ofthe

portfolio.24 Asinterestrateschange,themarketvalueofthesecuritiesintheportfoliochanges.

The

difference

between

the

market

value

and

the

book

value

is

the

unrealized

net

gain

(or

loss)

positionoftheportfolio,line5. AsoftheendofSeptember2012,theportfoliohadan

unrealizedgainof$249billion,reflectingagainoneachofthethreetypesofsecurities

holdings.25 September2012isthelastpublishedinformationonthepositionoftheportfolioas

ofthewritingofthispaper;however,asimilarcalculationispossibleatanytime. Inparticular,

theFederalReserveBankofNewYorkpublishestheCUSIPofeverysecurityheldintheSOMA

portfolio. CombiningtheseCUSIPswithmarketpricesforthesecuritiesallowsforthe

calculationonany

dayof

the

market

value

of

the

Federal

Reserves

portfolio.

Arough

calculationoftheunrealizedgainorlosspositionoftheportfolioisalsopossible.26

24ThequarterendmarketvalueoftheSOMAportfolioispublishedintheFederalReserveBanksCombined

QuarterlyFinancialReports(Unaudited),availableat

http://www.federalreserve.gov/monetarypolicy/bst_fedfinancials.htm#quarterly. Alternatively,theFederal

ReserveBankofNewYorkpublishestheCUSIPsofallofthesecuritiesintheFederalReservesportfolio. Matching

theseCUSIPswithcurrentmarketpricesallowsforanestimateofthecurrentmarketvalueoftheportfolio.25Importantly,eveniftheSOMAportfoliowasinanunrealizednetlossposition,theabilityoftheFederalReserve

toimplementmonetarypolicywouldnotbehampered.26Inadditiontothemarketpriceoftheportfolio,theamortizedcostoftheportfolioisrequiredtocalculatethe

unrealizedgainorlossposition. Inrealtime,amortizedcostcanbeeasilyapproximatedbytheparvalueofthe

portfolio,whichispublishedweekly,andthenetunamortizedpremiums,whichareincludedintheweekly

publicationofthebalancesheetandareexplicitlypublishedquarterly.


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Table3:ValueoftheSOMAportfolioasofSeptember30,2012

($billions)

Treasuries AgencyDebt AgencyMBS TotalSOMA

1.Parvalue* 1,648 85 848 2,581

2.Netpremiums 131 1 3 135

3.Amortizedcost 1,779 86 851 2,716

4.Marketvalue 1,968 92 904 2,964

5.UnrealizedGain/Loss 189 6 53 248*ParvalueasofSeptember28,2012fromtheH.4.1StatisticalRelease.

Source:FederalReserveBanksCombinedQuarterlyFinancialReport,September2012.

3 ProjectionsassumptionsInordertoconstructprojectionsoftheFederalReservesbalancesheet,assumptionsabout

many

of

the

details

of

the

balance

sheet

and

its

evolution

must

be

made.

The

following

subsectionsreviewassumptionsmadeaboutkeylineitemsofthebalancesheet. Adetailed

descriptionoftheseandadditionallineitemsisfoundinAppendix1.

3.1 InterestrateassumptionsToevaluatethecurrentandfuturevalueofsecurities,andthereforetheSOMAportfolio,

assumptionsmustbemadeaboutthepathofinterestratesovertheprojectionperiod. Forthis

analysis,werelyoninterestrateprojectionsfromtheDecember2012BlueChipforecastfor

thefederalfundsrateandthetenyearTreasuryrate. Weusethemeanquarterlyratesfrom

2012:Q4through2014:Q1,theannualratesfrom2014through2018,andthe5yearaverage

ratefrom20192023.27 Theassumedpathforthefederalfundsrateandtheyieldontheten

yearTreasurynoteareshowninFigure9. Thefederalfundsrateremainsinthe0topercent

rangeuntilthefirstquarterof2015. ThisBlueChipforecastrisesslightlyearlierthaninthe

October2012FOMCstatementandsubsequentcommunicationsbyFederalReserveofficials;in

otherwords,theBlueChipforecast,andthereforetheforecastusedinthispaper,isnotthe

FOMCforecast. Afterthatpoint,therateisprojectedtoriseandstandat3.8percentin2025.

TheyieldonthetenyearTreasurynotealsorises,fromitscurrentlowlevelof1.7percentto

4.9percentattheendoftheprojectionperiod. Theseforecastsdonotrepresenttheviewsof

27Weusethe5yearaverageinterestrateasourvaluein2024and2025.


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theFederalReserveoritsstaff. Theresultsofthesimulationspresentedinthispaperwouldbe

differentunderalternativeassumedpathsformarketinterestrates.

Toperformtheassetvaluationsthatwillberequired,however,anentireyieldcurveisneeded.

Asaresult,wecreateayieldcurveateachpointintimeovertheprojectionperiodusing

historicalrelationshipsbetweenthefederalfundsrate,thetenyearTreasuryrateandselected

intermediatetenors. Assetvaluationisneeded,forexample,toprojecttheeffectonreserves

ofsellingMBSasenvisionedintheFOMCsexitprincipleswhenasecurityissold,reserves

declinebythesale(market)priceofthesecurity,notbytheparvalue. Thehigherthemarket

valueofthesecurity,themorereserveswouldbedrainedthroughthesale. Thelowerthe

marketvalue,thereversewouldbetrue. MoredetailsareprovidedinAppendix2.

3.2 NeartermbalancesheetassumptionsThissubsectionreviewsourprojectionmethodologyforselectedassetandliabilityitemsthat

areofparticularinterest. Allelementsofthebalancesheetareprojected,butweleavethose

oflessinteresttoAppendix1.

3.2.1 SOMAportfolioTheevolutionoftheSOMAportfolioisintendedtobeconsistentwiththeFOMCstatementon

December12,2012. Inparticular,weassume:

(1)Thematurityextensionprogram(MEP),whichstartedinSeptember2011,iscompletedattheendof2012,asis$40billioninMBSpurchasespermonth;

(2) ReinvestmentofprincipalpaymentsfromagencysecuritiesintoagencyMBScontinuesinthenearterm,wherebynearterm,wemeantheperiodoftimebetweennowand

thebeginningofanexitstrategyfromthecurrentaccommodativemonetarypolicy

stance.28

(3)Additionalpurchasesofsecuritiesareconductedin2013atapaceof$45billionpermonthinlongertermTreasurysecuritiesand$40billionpermonthinagencyMBS. As

thecurrentpurchaseprogramisopenendedandconditionalonmacroeconomic

28TheexitstrategyandothertimingissueswillbediscussedinfurtherdetailinSection3.3.


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outcomes,weusezero,$500billion,and$1trillionintotalpurchasesin2013to

illustratethepossiblebalancesheetcontoursandincomeimplicationsoftheopen

endedprogram. Ofnote,the$1trillionprogramisinlinewiththemedianresponsein

theOctober2012PrimaryDealersurveyconductedbytheDesk. Thepurchasesof

Treasurysecuritiesareassumedtobeinthematuritydistributionannouncedbythe

DeskinconjunctionwiththeFOMCstatementonDecember12,whichhasroughlythe

samenetdurationasinasinthematurityextensionprogram.

GiventheinitialcompositionoftheSOMAportfolioonOctober31,2012,theportfolioevolves

overtime. WeadjustthematuritystructureofholdingsofTreasurysecuritiesandagency

securitiesthroughtimetoreflect(1)through(3)andthepassageoftime. Moreover,the

forecastforfuturepurchasesimposestheassumedconstraintthatSOMAholdingsthatanyone

CUSIPremainbelow70percentofthetotalamountoutstandinginthatCUSIP,asannouncedby

theFederalReserveBankofNewYork.

SimilartotheuseofBlueChipprojectionsforinterestrates,weturntopublicprojectionsfor

theTreasurysissuanceofmarketabledebt. Weuseprojectionsofboththeamountandthe

maturityofTreasuryissuanceinordertoprojectsecuritiesavailableforpurchasebytheFederal

Reserve. WeuseTreasuryissuanceasofOctober2012,andfromthatpointforward,coupled

withtheCongressionalBudgetOfficesJanuary2012projectionsfortotalTreasurydebt

outstanding,wegeneratethelevelandmaturitystructureofmarketabledebtoutstanding.29 In

addition,weassumethattheaveragematurityofTreasurydebtoutstandingextendsfromits

currentlevelof62monthsto70monthsby2015,roughlyconsistentwiththeTreasurysstated

intentionsasofNovember2011andAugust2012.30 Therefore,futureTreasurypurchasesare

associatedwithcouponsthatevolveovertimereflectingprojectionsininterestrates,Treasury

issuance,andthe70percentownershiprule.

29AsofJanuary2013,thebudgetmeasuresagreedtosofaraspartoftheAmericanTaxpayerReliefActof2012

wouldlikelynotmateriallyaffectourprojections. Othermeasuresthatcouldbeadoptedlaterinthespringof

2013aredifficulttoforecastandbeyondthescopeofthispaper.30Refertohttp://www.treasury.gov/presscenter/pressreleases/Pages/tg1665.aspxand

http://www.treasury.gov/presscenter/pressreleases/Pages/tg1349.aspx.


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AcoupleofparticularsregardingFederalReserveaccountingandvaluationofsecuritiesshould

benoted. Specifically,FederalReserveaccountingrecordsthesecuritiesholdingsatfacevalue

andrecordsanyunamortizedpremiumordiscountintheotherassetscategory.

Consequently,wemustprojectboththefacevalueoftheportfolioandtheassociated

premiums. Toprojectpremiumsonfuturesecuritiespurchasesweneedtocalculatethe

marketvalueofsecuritiesinthefuture. Wetakethemarketvalueforsecuritiesasthepresent

discountedcashflowofthesesecuritiesusingthecouponratetogeneratecashflowsandthe

yieldcurvesdescribedinSection3.1andAppendix2todiscountthesecashflows. The

premiumisthedifferencebetweenthefacevalueandthemarketvalueofthesecurity.

Treasurysecuritiesthatarerolledoveratauctionareassumedtobepurchasedatpar,and

thereforehavenopremium.

ForMBSreinvestment,weneedtoprojectthecouponofthesecuritiesthatwillbepurchased.

ThemodelusedforthatisdescribedinAppendix2. Becausereinvestmentsareassumedto

continueonlyinthenearterm,weassumethatpurchasesofMBStakeplaceataprice4

percentabovefacevalue,consistentwithrecentMBSreinvestmentactivity.

3.2.2 LiabilitiesandcapitalInourmodeling,twoitemsareimportantexogenousdriversofthebalancesheetcontourFR

notesandcapitalpaidin. Forsimplicity,weassumethatFRnotesgrowinlinewiththeBlue

ChipforecastfornominalGDP. Capitalpaidinisassumedtogrowatitsdecadeaverageof15

percentperyear,andsurplusisequatedtocapitalpaidin. Thisgrowthrateplaysaroleinthe

longruntrendgrowthrateoftheSOMAportfolio.

Reservebalances,animportantliabilityitemfortheFederalReserve,areendogenoustoour

projectionsandingeneralcalculatedastheresidualofassetslessotherliabilitieslesscapitalin

thebalancesheetprojections. However,weassumeaminimumlevelof$25billionissetfor

reservebalances. Thatlevelisroughlyconsistentwiththelevelofreservebalancesobserved

priortothefinancialcrisis. BothFRNotesandcapitalaretrendinghigherintheseprojections.

Tomaintainreservebalancesat$25billion,weassumethattheDeskbeginstopurchase

Treasurybills. Purchasesofbillscontinueuntilthesesecuritiescompriseonethirdofthe


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FederalReservestotalTreasurysecurityholdingsasnotedabove,abouttheaverage

proportionofTreasuryholdingspriortothecrisis. Oncethisproportionofbillsisreached,we

assumethattheDeskbuyscouponsecuritiesinadditiontobillstomaintainanapproximate

compositionoftheportfolioofonethirdbillsandtwothirdscouponsecurities.

3.3 ExitstrategyassumptionsforthebalancesheetFortheneartermprojections,wenotethattheFOMCcompletedtheMEPand$40billionin

MBSpurchasesinDecember2012,andassumetheFOMCbeginsoneofthethreepurchase

scenarios($0,$500billion,or$1trillion)in2013. Furtheroutintheprojectionperiod,webase

ourprojectionsonthegeneralprinciplesfortheexitstrategythattheFOMCoutlinedinthe

minutesoftheJune2011FOMCmeeting.31 TheCommitteestatedthatitintendedtotakethe

followingstepsinthefollowingorder:

(1)CeasereinvestingsomeorallpaymentsofprincipalonthesecuritiesholdingsintheSOMA;

(2)Modifyforwardguidanceonthepathofthefederalfundsrateandinitiatetemporaryreservedrainingoperationsaimedatsupportingtheimplementationofanincreasein

thefederalfundsratewhenappropriate;

(3)Raisethetargetfederalfundsrate;(4)Sellagencysecuritiesoveraperiodofthreetofiveyears;and(5)Oncesalesbegin,normalizethesizeofthebalancesheetovertwotothreeyears.

Theseprinciplesrepresentaroughguidetotheexitstrategy. Inparticular,atthattime,the

Committeestatedthatispreparedtomakeadjustmentstoitsexitstrategyifnecessaryinlight

ofeconomicandfinancialdevelopments.

Tocompletetheprojections,however,weneedtomakeadditionalassumptions. Wetie

changesintheSOMAportfoliotothedatethefederalfundsrisesfromitseffectivelower

bound,which,basedontheBlueChipforecasts,weassumeisMarch2015. Weassumethat

thereinvestmentofsecuritiesendssixmonthsbeforethisdate. Wedonotexplicitlymodelthe

31MinutesoftheFederalOpenMarketCommittee,June2122,2011,availableat

http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20110622.pdf.


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useofreservedrainingtools.32 Weassumethatsalesofagencysecuritiesbeginsixmonths

afterthefederalfundsratebeginstoriseandthatthebalancesheethasreturnedtonormal

sizeoveraboutthreeyears. Ininterpretingnormalsizewerelyonthe$25billionminimum

levelforreservebalancesasnormal. WesummarizetheassumedexitstrategyinTable4.33

Table4:Keyassumptionsusedinbalancesheetprojections

Assumption

$02013

Purchases

$500bn2013

Purchases

$1tr2013

Purchases

MEPTreasuryPurchases

Amount $667 billion $667 billion $667billion

Length 15 months 15 months 15months

Firstmonth Oct11 Oct11 Oct11

Lastmonth Dec12 Dec12 Dec12

MEPTreasurySalesorRedemptions

Amount $667 billion $667 billion $667billion

Length 15 months 15 months 15months

Firstmonth Oct11 Oct11 Oct11

Lastmonth Dec12 Dec12 Dec12

CurrentPortfolioStrategy

Agencyreinvestments AgencyMBS AgencyMBS AgencyMBS

2013TreasuryandMBSPurchases

Amount N/A $500billion $1trillion

Length N/A 6 months 12monthsFirstmonth N/A Jan13 Jan13

Lastmonth N/A Jun13 Dec13

MBSpurchasepace N/A $40bn/month $40bn/month

Treasurypurchasepace N/A $45bn/month $45bn/month

ExitStrategy

FedFundsliftoff Mar15 Mar15 Mar15

Redemptionsstart Sept14 Sept14 Sept14

Agencysales

Salesstart Sept15 Sept15 Sept15

Salesend Aug19 Aug19 Aug19

32Iftermdepositsorreverserepurchaseagreementswereusedtodrainreservespriortoraisingthefederalfunds

rate,thecompositionofliabilitieswouldchange:Reservebalanceswouldfallastermdepositsandreverse

repurchaseagreementsrose. Presumably,thesedrainingtoolswouldbewounddownasthebalancesheet

returnedtoitssteadystategrowthpath,sothattheprojectedpathforSOMAholdingspresentedhereremains

valid.33Iftheexpecteddateofthefederalfundsliftoffislaterthanassumedhere,thestartdatesfortheexitstrategy

principleswillsimilarlybedelayedbutthecontoursoftheprojectionspresentedherewillberoughlyunchanged.


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Otherlineitemsonthebalancesheetcontinueontheirprojectedpathasnotedabove.

3.4 IncomeprojectionsassumptionsBasedonprojectionsofthesizeandcompositionoftheFederalReservesbalancesheet,a

projectedpathforinterestrates,andsomeotherassumptions,wecancalculateanimplied

projectionfortheFederalReservesearnings,expenses,andremittancestotheTreasury.

Again,thedetailsofReserveBankaccountingmatter,butwewilldiscusstheprimary

determinants,whichareinterestincome,interestexpense,capitalgainsorlosses,and

remittancestotheTreasury. Thissectiondescribesthekeyassumptionsbehindtheincome

projection,whileAppendix1providesadditionaldetails.

3.4.1 SOMAinterestincomeNotsurprisingly,sincetheSOMAportfolioisthelargestassetitem,itgeneratesthebulkof

FederalReserveBankearnings. InterestincomereflectsthecouponpaymentsfromtheSOMA

portfoliosholdingsofsecuritiesminustheamortizationofpremiumsonthoseholdings. To

createtheprojectionsofinterestincome,therefore,wemusttracktheevolutionofthe

portfoliofrompurchases,sales,andmaturingsecurities. Asthecompositionoftheportfolio

evolves,thecouponontheportfolioevolves. Theamortizationofpremiumsreducesinterest

income,sotheassumptionsaboutthepremiumsonthesecuritiespurchasedaffectthe

calculationofinterestincome.

FocusingonincomefromTreasurysecurities,forsimplicity,wedividetheSOMAportfolio

holdingsintobucketsbymaturityinsteadofanalyzingeachCUSIP. Specifically,weaggregate

CUSIPSbymonthofmaturity,treatingallsecuritiesmaturingwithinagivenmonthasasingle

security. Basedonthesebuckets,wecalculatetheWACoftheportfolioandmultiplythatby

theholdings. Next,wesubtractoffamortizednetpremiums.

TheprojectionoftheSOMAportfolioandtheassociatedpremiumswerediscussedinSection

3.2.1. AsofOctober31,2012,theWACoftheTreasuryportfolioisknown. Fortheprojection,

weseparatepurchasesofsecuritiesfromreinvestment. Purchasesoccurinthesecondary

marketatprojectedmarketprices. Overtime,theaveragecoupononTreasurysecuritiesinthe

secondarymarketevolvesasexistingTreasuryissuanceagesandprojectednewissuanceis


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introducedintothemarket. ThestartingpointofthecouponratesofexistingTreasury

securitiesarefromtheTreasurysMonthlyStatementofthePublicDebtasofOctober31,2012.

Weassumethatanypurchasesinthesecondarymarketinatargetedbuckethaveanaverage

couponrateequivalenttotheaveragecouponofTreasurysecuritiesinthemarketwith

remainingmaturityinthisbucket. Asaresult,wecalculatethecurrentmarketvalueofthe

securitiestocomputetheimpliedpremium. Reinvestmentofmaturingsecurities,however,is

doneatauction,andweassumethatnewlyauctionedsecuritiesareissuedatpar,and

thereforehavenopremiumassociatedwiththem. Forreinvestment,weprojectfuturecoupon

ratesonnewlyissuedTreasurysecuritiesusingaregressionbasedtermstructuremodelas

outlinedinAppendix2.

ForholdingsofMBS,weseparateMBSpurchasedduringthefirstlargescaleassetpurchase

programfromNovember2008toMarch2010andthereinvestmentpolicythroughOctober

2012,andthoseprojectedtobereinvestedandpurchasedin2013andbeyond. Thisdistinction

isimportantbecausethecouponsonMBSpurchasedundertheassetprogramaregenerally

higherthanthecurrentproductionMBS. TheMBScurrentlyheldontheFederalReserves

balancesheethavecouponsthatrangefrom2.5to6.5percent. Thehighercouponsecurities

tendtohavehigherpremiumsassociatedwiththem. MBSreinvestmentisassumedtotake

placeincurrentcouponsecurities,whichhavebeenpurchasedatapremiumthatisassumedto

be4percentabovefacevalue.

3.4.2 InterestexpenseOvermuchoftheFederalReserveshistory,interestexpensehasbeenmodest. Interest

expensederivesfrominterestbearingliabilities,inparticulartheforeignreverserepurchase

agreementpoolandreservebalances. Overthepastdecadeorso,theforeignrepopoolhas

averagedroughly$50billionandpaysinterestatarateconsistentwithovernightreporates.

Asaresult,thisinterestexpenseisrelativelysmall. Asmentionedabove,priorto2008,the

FederalReservedidnothavetheauthoritytopayinterestonreservebalances. Currently,

althoughreservebalancesarequiteelevated,at$1.5trillion,theIOERrateis25basispointsat

anannualrate,whichimplieslessthan$4billionpaidininterestoverthecourseofthisyear.


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Interestratesareprojectedtorise,however,andweassumethattheIOERratewillbeequalto

thefederalfundsrate.34 Asaresult,interestexpensewillrise. But,intheprojections,reserve

balancesareprojectedtodecline,sotheneteffectoninterestexpensedependscriticallyon

thetimingoftheriseininterestratesandthedeclineinreservebalances.

3.4.3 CapitalgainsorlossesFederalReserveBankaccountingonlyrealizesgainsorlossesontheSOMAportfolioifa

securityissold,andhistorically,theFederalReservesoldsecuritiesinfrequently.35 In2011,

MEPsalesrecordedaslightcapitalgain. Inaddition,prepaymentsonMBSresultina

realizationofagainoralossonthatsecuritybasedontheamountoftheprepayment.36 For

theseprojections,wecalculatecapitalgains(losses)asthemarketvalueofthesecuritiesbeing

soldminustheirparvalueandunamortizednetpremiums. Themarketvalueiscalculatedusing

theyieldcurvesanddiscountedcashflowmethodologydescribedinAppendix2. In

determiningtheFederalReservesincomeinagivenperiod,aftertheearningsandexpenses

discussedabovearecalculated,capitalgains(losses)areadded.

3.4.4 Otheritems,dividends,transferstosurplus,andremittancestotheTreasuryThevariousothercomponentsthatcontributetonetincomearesmallandnotedin

Appendix1. Twoadditionaladjustmentstonetincomearemadebeforethecalculationof

remittancestotheTreasuryiscomplete. Asnotedabove,theFederalReserveisstatutorily

requiredtopaydividendstomemberbanks. Inaddition,theReserveBankstransferfundstoa

surpluscapitalaccounttoensurethatsurplusalwaysequalscapitalpaidin. Remittancestothe

Treasuryinanyperiodarecalculatedasallremainingnetincomeaftertheseadjustments.

RemittancestotheTreasury,however,canneverbenegative. Asnotedabove,ifthereisan

operatinglossinsomeperiod,thennoremittanceismadeuntilearnings,throughtime,have

34Thisisasimplifyingassumption. Inthefuture,dependingontheoperatingframeworkandotherfactors,the

IOERratecouldbeabove,equal,orbelowthefederalfundsrate.35TheassetsheldbytheSOMAportfoliothataredenominatedinforeigncurrenciesarerevalueddailyand,asa

result,canexperiencegainsandlosses. Thesechanges,however,aresmallcomparedtothesizeofthebalance

sheetandnetincome.36Dollarrolltransactions,whichinvolvebothapurchaseandasaleofMBScanalsoresultinrealizedgainsor

losses.


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beensufficienttocoverthatloss. Thevalueofthefutureearningsthatwillberetainedtocover

thislossisadeferredasset.

4 ProjectionsInthissection,webeginwiththreeoptionsfortheprojectionofthebalancesheet:no

purchasesin2013,$500billioninpurchasesin2013;and$1trillioninpurchasesin2013. These

baselinescenariosprovideausefulguidetohowtheFederalReservesbalancesheetmight

evolveunderarangeofpossibleassumptions. Next,weexamineascenariowhereinterest

ratesareuniformly100basispointshigherthaninthebaselineafterliftoff. Althoughthis

shockparticularlytheparallelshiftisanunlikelyoutcome,wepresentittoshowtheinterest

ratesensitivityoftheportfolio. Aswillbeshown,thecontoursoftheprojectionsintheshock

scenarioaresimilartothoseunderbaselineassumptionsforinterestrates,butthesizeof

capitallossesislarger,interestexpenseishigher,andremittancesarethereforelower. Finally,

wediscussascenariowhereinterestratesare100basispointslowerthaninthebaselineafter

liftoff. Again,thecontoursoftheprojectionsaresimilartothebaseline,withlossesand

interestexpensesomewhatlower. Westressagainthattheseprojectionsaretheresultofthe

underlyingassumptionsmadeaboutinterestratesandpolicydecisionsand,asaresult,arenot

forecaststhemselves. Thepointoftheanalysishereistoestablishaframeworkforsuch

projections,anddifferentassumptionswould,ingeneral,resultindifferentprojections.

4.1 Baselinescenarios4.1.1 BalancesheetFigures10and11presenttheprojectionsofkeybalancesheetlineitemsunderourthree

baselinescenarios. AsshowninthetopleftpanelofFigure10,SOMAholdingsmoveupslightly

throughtheendof2012reflectingthe$40billionpermonthpurchasesofMBS. In2013,under

withnofurtherpurchases(thesolidline),theportfolioremainsfairlysteadyatitsend2012

level.37 With$500billionor$1trillioninfurtherpurchases(thebluedashedandreddotted

37TherearesomeagencyMBSpurchasedduring2012thatsettlein2013,causingtheSOMAportfoliotoincrease

slightlyduring2013.


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lines,respectively),theportfoliorisesthrough2013,growingat$85billionpermonth. The

peaksizeoftheportfolioreflectsthesizeofthepurchaseprogram:withnofurtherpurchases,

theportfolioreaches$2.75trillion,with$500billion,$3.25trillion,andwith$1trillion,$3.75

trillion. Thelevelofreservebalancesreflecttheassetprograms,withreservebalancestopping

outat$1.7trillion,$2.2trillionand$2.7trillioninthezero,$500billion,and$1trillionasset

purchaseprograms,respectively. Afterpurchasesend,undertheassumptionthattheFOMC

beginstoallowallassetholdingstorollofftheportfolioasthefirststepintheexitstrategy,

withthetimingimpliedbytheinterestrateprojections,SOMAholdingsbegintodecline.

NoticethatSOMATreasuryholdings,thetoprightpanel,remainconstantevenwhenrolloff

begins. ThisfactisaresultoftheMEPreducingholdingsofshorterdatedTreasurysecuritiesto

nearzero. MBSholdings,thebottomleftpanel,ontheotherhand,begintocontract.

BeginninginSeptember2015,againconsistentwithourassumptionsabouttheexitstrategy,

MBSsalesbegin,andtheseholdingsfalltozerobyAugust2019. Inthenofurtherpurchases

scenario,thesizeofthebalancesheetisnormalizedinApril2018(32monthsaftersalesbegin),

whileinthe$500billionand$1trillionpurchasescenarios,normalizationoccursinOctober

2018(38months)andFebruary2019(42months),respectively.38

ThereductioninthesizeoftheSOMAportfolio,alongwiththeprojectedgrowthofReserve

BankcapitalandFRnotes,resultsindeclinesinthelevelofreservebalances,showninthe

bottomrightpanelofFigure11. Asdescribedabove,weassumethatreservebalancesarenot

allowedtofallbelow$25billion. Therefore,byearly2019inallscenarios,theseprojections

assumethattheDeskagainstartstoreinvestmaturingTreasurysecuritiesandbegins

purchasesofTreasurysecurities. Afterthispointintime,theSOMAportfolioexpandsinline

withFRnotesandcapitalandreservebalancesremainconstantandunconventional

monetarypolicyhasessentiallyunwound.

38AlthoughthetimingofthenormalizationofthebalancesheetisslightlybeyondwhattheCommitteeanticipated

intheexitprinciples,thesaleswindowweassumecouldbeshortenedandthenormalizationdatecouldfallwithin

thewindow. Theeffectofsellingoverashortertimeperiodonincomeisambiguous: whileacceleratedsales

wouldtendtoincreaserealizedlosses,interestexpenseshouldfallasreservesdecline.


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4.1.2 IncomeFigure12showsthepathofReserveBanknetincomeunderthethreebaselinescenarios.

BecauseofthelargesizeoftheSOMAportfolio,interestincomeiselevatedthrough2015inall

scenarios,withthelargerportfolioshavinghigherinterestincome. AstheSOMAportfolio

beginstocontractwiththeassumedstepsintheexitstrategy,interestincomedeclinesthrough

mid2018. Afterreservebalancesreach$25billion,Treasurypurchasesresume,expandingthe

portfolio,causinginterestincometorise.

Asnotedabove,interestexpensereflectsboththelevelofthefederalfundsrateandthelevel

ofreservebalances. ThefederalfundsrateintheBlueChipforecastbeginstorisein2015,and

interestexpenseriseswithit. However,in2016,interestexpensebeginstomoderate,asthe

declineinreservebalancesmorethanoffsetstheriseinthefederalfundsrate.

Intermsofcapitalgainsorlosses,TreasurysecuritiessalesconductedundertheMEPresultina

smallgainbecauseofthelowlevelofmarketinterestratesin2012andtherelativelyhigher

coupononthesecuritiessold.39 Duringtheexitstrategy,however,MBSsalesresultinrealized

losses. Overthefouryearsalesperiod,September2015toAugust2019,theselossesaverage

roughly$18billionperyearacrossallthreescenarios. Thisamountmayseemnotablebut

shouldbecomparedtothecumulatedearningsfromthelargerportfolio.

Onnet,remittancestotheTreasuryremainelevatedbyhistoricalstandardsthrough2015,but

thendecline. Forthescenarioswithadditionalpurchasesin2013,remittancesfalltozerofora

numberofyears,reflectingsomerealizedlossesassociatedwithsalesandhigherinterest

expense,andadeferredassetisrecorded. Thelargertheprogram,thelargerthesalesand

interestexpense,andsothelargeristhepeakdeferredasset.

Forthe$1trillionpurchasescenario,thereisadeferredassetthatlastsforfouryearsandthat

peaksat$40billion. Forcomparison,thesurpluscapitalaccountthatis,retainedearningsis

aboutthesamesizeasthispeak,andtheaverageannualremittancestotheTreasuryoverthe

projectionperiodisslightlylarger. Oncesalesarecompletedandtheportfolioreachesits

39ThevastmajorityofsecuritiessoldundertheMEPwereshortdatedcoupons,notbills.


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steadystategrowthpath,remittancestotheTreasuryriseslowlyastheportfolioexpandsand

interestincomerises. Remittancesin2025arecloseto$45billion.

Whencomparingthecumulativeremittancesgeneratedfromalternateprograms,the$1

trillionprogram,whichresultsinthelargestdeferredasset,resultsincumulativeremittances

thatareroughly$60billionbelowthescenariowithnofurtherpurchases,orroughly$5billion

lessonaverageperyear. Ofcourse,theoveralleffectonthefederalgovernmentsfinancesis

morecomplicated. Forexample,iftheseadditionalassetpurchasesprovidemeaningful

economicstimulus,theincreaseingovernmentrevenuesfromfastereconomicgrowthcould

morethanoffsetthereductioninremittances. Further,iftheassetpurchaseslowerinterest

rates,theinterestexpenseofthefederalgovernmentislower.

Asdiscussedabove,onlyrealizedgainsorlossesaffecttheFederalReservesincome.

Nevertheless,giventhelargeSOMAportfolioandtheprojectedriseininterestrates,underthe

baselineprojections,theportfolioisinanunrealizedlosspositionbeginningin2014. This

unrealizedlosspositioncontinuestogrowthrough2017,butsubsequentlydiminishesasthe

portfolioshrinksthroughredemptionsandsales.

4.2 HigherinterestratesPolicymakershavealsodiscussedtheinterestratesensitivityoftheSOMAportfolioandthe

implicationsoflargeincreasesininterestratesonFederalReservenetincome.40

Toexplore

thispossibility,asshowninFigure9underthehigherinterestratescenario(thedashedline),

thefederalfundsrateandtenyearTreasuryyieldriseatafasterpaceatliftoff,andafterone

yearare100basispointshigherthanthebaselineratesovertheremainderoftheprojection

period. Onecouldimagineanincreaseininflationorinflationexpectationscouldleadtosucha

result;modelingthistypeofeconomicenvironmentisbeyondthescopeofthispaperandthe

shockisusedsolelytodemonstrateintheinterestratesensitivityoftheportfolio. Wenote,

40Forexample,theminutestotheDecember2012FOMCmeetinghighlightedthat[p]articipantsalsodiscussed

theimplicationsofcontinuedassetpurchasesforthesizeoftheFederalReservesbalancesheet.Dependingon

thepathforthebalancesheetandinterestrates,theFederalReservesnetincomeanditsremittancestothe

Treasurycouldbesignificantlyaffectedduringtheperiodofpolicynormalization,availableat

http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20121212.pdf.


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however,thatthisshockisbroadlyconsistentwiththetenhighestinterestrateprojections

fromrespondentstotheBlueChipsurvey. Inotherwords,theseinterestratesareatthehigh

endofmarketexpectations,butareseenasplausibleoutcomesbyprofessionalforecasters. In

thebaselineinterestrateprojection,thetenyearTreasuryyieldrisesby2percentagepoints

betweenend2014andend2016. Bycontrast,the100basispointshockimpliesthetenyear

Treasuryyieldisincreasingby3percentagepointsoverthesetwoyears.

Thereareacoupleofwaystoputthesizeofthisshockinperspective. Tostart,thissizeshock

isabovethatexpectedbytherespondentstotheDecember2012BlueChipsurveywiththetop

tenhighestinterestrateexpectations(roughly20percentofthesample),andthusisprobably

comfortablyabovemostmarketparticipantsinterestrateprojections. Inaddition,fora

historicalcomparison,from1978topresent,thestandarddeviationofthetwoyearchangein

the10yearTreasuryyieldis1.6percentagepoints. Asaresult,thishigherinterestrate

scenarioshouldbeseenasasomewhatunlikelyscenario,butnotanimplausibleone. Of

course,totheextentthatinflationexpectationshavebecomebetteranchoredthroughtime,

thisincreaseininterestratesmaybeevenlessprobablethanthehistoricalrecordmaysuggest.

TheinterestrateshockdoesnotchangethebroadcontoursoftheFederalReservesbalance

sheet,asshowninFigure13. Thehigherinterestratepathdoes,however,changetheincome

projectionsnotably,andasaresult,leadstoadifferentpathofremittancestoTreasury.

Broadlyspeaking,thehigherinterestratepathreducesremittancesasinterestexpenserises

andlossesonsecuritiessalesgrow. Inthelongerrun,afterthesizeofthebalancesheet

normalizes,thehighercouponrateonTreasurysecuritiespurchasedtokeeppacewiththe

growthoftheFederalReservesbalancesheetactuallypushesupremittances.

ThespecificsoftheincomeprojectionswithhigherinterestratesareshowninFigure14.

SOMAinterestincomeremainssimilartothebaselinebecausethesecuritiesintheSOMA

portfoliohavealreadybeenpurchasedandtheircouponsarefixed. However,interestexpense

becomesgreateroncethefederalfundsrateliftsofffromthelowerboundbecauseofthe

higherinterestratepath. Inaddition,becausesalesofMBSoccurwhenlongerterminterest

ratesarehigherthaninthebaseline,realizedcapitallossesaresomewhatgreater. Overall,in


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thescenariowithnoadditionalassetpurchasesin2013,thehigherinterestratescause

remittancestotheTreasurytofalltozeroandasmalldeferredassetiscreated. Inthescenario

with$1trillionadditionalassetpurchasesin2013,inthehigherinterestratescenario,the

deferredassetpeaksat$125billion,substantiallyhigherthanunderthebaseline. Moreover,

remittancestotheTreasuryarehaltedfor6years. Thisreductioninearningsinthisscenario

reflectstheinterestrateriskthattheFederalReserveistakingonwithassetpurchases. More

purchasestendtoleadtolargerrealizedlosses,andthelossesareevenlargerunderthehigher

interestratescenario. Forcomparison,however,inthehigherinterestratescenario,

cumulativeremittancesareonlyabout$45billionlowerthaninthescenariowithoutthe

interestrateshock. Underallscenarios,remittancestotheTreasuryresumebyend2022. As

notedabove,totheextentthatthepoliciesareeffectiveinstimulatingtheeconomy,overall

governmentrevenueswouldbeboostedonnet,despitethesomewhathigherlossesatthe

FederalReserve.

Theseoutcomes,however,shouldbeviewedinalongertermcontext. Overall,averageannual

remittancestotheTreasuryeveninthisshockscenarioremainabovetheaverageannual

remittancesof$25billionrecordedpriortothecrisis.

4.3Lower

interest

rates

JustasitispossibleforratestobehigherthanprojectedbytheBlueChipconsensusforecast,

ratesmaybelowerthantheconsensusforecast. Inordertocharacterizethispossibility,Figure

15displaysthefederalfundsand10yearTreasuryyieldundertheassumptionthattherisein

ratesisneitherashighnorasfastasinthebaselineconsensusforecast,andinthelongrun,

ratesare1percentagepointlowerthaninthebaseline. Possiblescenariosthatcouldproduce

thisoutcomethroughthemediumrunincludeaslowerorweakerrecoverythancurrently

expected

by

market

participants.

Rather

than

rising

by

200

basis

points

in

the

longer

run,

the

10yearyieldmovesuponly100basispoints,amodestlevelcomparedtolongerrunaverages.

Thispathisbroadlyconsistentwiththetenlowestinterestrateprojectionsfromthe

respondentsoftheBlueChipsurvey.


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AsshowninFigure16,andsimilartothehigherinterestrateshock,thelowerinterestrate

shockdoesnotchangethebroadcontourofthebalancesheetprojection. Nevertheless,the

incomeprojectionandthereforeremittancestotheTreasurydoesmateriallychange,asshown

inFigure17. Ingeneral,thelowerinterestratepathmitigateslossesfromsalesofagencyMBS

anddampensexpensefromreservebalances,boostingremittancesrelativetothebaselineto

somedegree. Asaresult,regardlessoftheamountofpurchasesin2013,remittancestothe

Treasurystaypositiveinallyearsoftheprojectionandnodeferredassetisrecordedonan

annualbasis. Mirroringtheresultsinthehigherinterestratescenarios,inthelongerrun,the

lowercouponrateonTreasurysecuritiespurchasedtokeeppacewiththeexpansionofthe

balancesheetdepressesremittancesrelativetothebaselinecase. However,despitethelower

remittancesattheendoftheprojectionperiod,averageannualremittancesintheprojection

stillremainwellabovetheaverageannuallevelbeforethecrisis.

5 ConclusionInthispaper,wehaveoutlinedthemechanicsofandprojectionsfortheFederalReserves

balancesheetandincome. Underthebaselineprojections,derivedfrompubliclyavailable

forecastsabouttheeconomyandpublicstatementsbytheFOMC,theFederalReserves

balancesheetissubstantiallylargerthanithadbeenhistoricallyforsomeyearsuntil

contractinggraduallyduringtheexpectedexitperiod,andonlyreturningtoitslongrungrowth

pathinlate2018orearly2019. Thisresult,ifitisexpectedbymarketparticipantsandwereto

berealizedinpractice,wouldimplythatunconventionalmonetarypolicyactionswouldbe

holdinginterestratesdown,tosomedegree,foranumberofyears. TheFederalReserves

incomeandremittancestotheTreasuryareprojectedtoremainathistoricallyelevatedlevels

forafewmoreyears,reflectingtherelativelyhighyieldsearnedonlongertermTreasury

securitiesandMBS. However,remittancessubsequentlydeclineforatime. GiventheFOMCs

statedplantosellMBSatthetimethatpolicyaccommodationisbeingremoved,somelosses

areprojectedtoberealizedonthosesales. Moreover,theelevatedlevelofreservebalancesis

projectedtoleadtoincreasinginterestexpenseforsometime. Takentogether,remittancesto

Treasuryareprojectedtofalltoalowlevelortobehaltedforafewyearsandadeferredasset


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willbebookedontheFederalReservesbalancesheet. Subsequently,theFederalReserves

incomeisprojectedtoreturntoitslongertermtrendandremittancestotheTreasuryrebound.

Todemonstratetheinterestrateriskontheportfolio,andtounderscorethefactthatthese

projectionsarenotforecastsperse,butrather,theresultofasetofassumptions,weconsider

howincomemayevolvewitha100basispointshockupwardsordownwardstothebaseline

interestratepaths. Overall,higherinterestratesresultinhigherrealizedlossesonMBSsales

andhigherinterestexpense,bothofwhichcontributetoalargerdeferredasset,allelseequal.

Ontheotherhand,lowerinterestratesgeneratelowerrealizedlossesandlowerexpense,and

consequently,nodeferredassetisrecorded. Inallofthesimulations,however,lookingat

cumulativeremittancestotheTreasuryovertheperiodoftheuseofthebalancesheetasatool

forpolicysuggeststhatFederalReserveearningsareboosted,onnet,fromtheseactions. That

resultsuggeststhattheFederalReserveisnotimposingacostontheTreasury,butinstead,

howeverincidentally,providingadditionalrevenues. Ofcourse,anyandalloftheresultsarea

reflectionoftheassumptions,andnoneoftheassumptionsusedintheanalysisreflectofficial

viewsoftheFederalReserve. Rather,theassumptionsarederivedfrompubliclyavailable

information.


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BoardofGovernorsoftheFederalReserveSystem. 1976. BankingandMonetaryStatistics,

19141941.

Carpenter,Seth,Ihrig,Jane,Klee,Elizabeth,Boote,Alexander,andQuinn,Daniel. 2012. The

FederalReservesBalanceSheet:APrimerandProjections,FinanceandEconomicsDiscussion

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Edwards,CherylE. 1997. OpenMarketOperationsinthe1990s,FederalReserveBulletin,p.

859874.

FederalReserveBankofNewYork. 2011. DomesticOpenMarketOperationsin2010,

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http://www.newyorkfed.org/markets/Domestic_OMO_2010_FINAL.pdf

Garbade,KennethD.,Partlan,JohnC.,andSantoro,PaulJ. 2004. RecentInnovationsin

TreasuryCashManagement,CurrentIssuesinEconomicsandFinance,FederalReserveBankof

NewYork,vol.10,no.11,November.

Gurkayank,Refet,Sack,Brian,andWright,Jonathan. 2007. TheU.S.Treasuryyieldcurve:

1961tothepresent,JournalofMonetaryEconomics,p.22912304,November.

Ihrig,Jane,Klee,Elizabeth,Li,Canlin,Schulte,Brett,andWei,Min.2012. Expectationsabout

theFederalReservesBalanceSheetandtheTermStructureofInterestRates,forthcoming

FederalReserveFinanceandEconomicsDiscussionSeriespaper.

Judson,Ruth,andPorter,Richard. 1996. TheLocationofU.S.Currency:HowMuchis

Abroad?,FederalReserveBulletin,vol.82,p.883903,October.


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Meltzer,Allan. 2010. AHistoryoftheFederalReserve,Volume2,19511986,Universityof

ChicagoPress.

Rudebusch,GlennD. 2011. TheFedsInterestRateRisk,EconomicLetters,FederalReserve

BankofSanFrancisco,April11.


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Appendix1:Overviewofselectedbalancesheetitemsand

assumptionsunderlyingthebalancesheetandincomeprojections

Thisappendixprovidesdetailsabouttheforecastingprocedureforeachbalancesheetitem.

ThosenotspecificallydiscussedareheldattheirlevelasofOctober31,2012.

6 Balancesheet6.1 TreasurysecuritiesSOMATreasuryholdingsareassumedtoevolvethroughacombinationofoutrightpurchases

andoutrightsalesinthesecondarymarket,reinvestmentatauction,andmaturities.

Outrightpurchasesforthe$667billionMaturityExtensionProgram(MEP)havethematuritybucketsandtargetsannouncedbytheFederalReserveBankofNewYork:

MaturityExtensionProgrampurchasedistribution

(percent)

Nominalcouponsecurities TIPS

68years

810

years

1020

years

2030

years

32 32 4 29 3

Outrightpurchasesin2013aresimulatedaccordingtothematuritybucketsandtargetsasannouncedbytheFederalReserveBankofNewYork:

2013Treasurypurchasesdistribution(percent)

Nominalcouponsecurities TIPS

4 4.75

years

4.75

5.75

years

5.75 7

years

7 10

years

10 17

years

17 30

years

11 12 16 29 2 27 3

SecuritiesassumedtobeavailableforpurchasereflectthoseoutstandingontheMonthlyStatementofthePublicDebtasofOctober31,2012aswellasforecastsfor

futureissuance. HoldingsofanyparticularCUSIParelimitedto70percentoftheCUSIP

outstanding,consistentwiththeDeskscurrentpractice.

ThetotalparvalueofTreasurysecuritiesoutstandingreflectstheCongressionalBudgetOffices(CBO)projectionsfortotaldebtheldbythepublic.


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TheaveragematurityofTreasurydebtextendsfromitscurrentvalueof60monthsto70months,consistentwithobservationsmadebytheTreasuryBorrowingAdvisory

CommitteeinNovember2011andAugust2012.41

Theproceedsfrommaturingsecuritiesarereinvestedatauctionatratesconsistentwiththe

Blue

Chip

forecast

for

interest

rates,

as

discussed

in

Appendix

2.

Auction

sizes

are

determinedbytheamountoftotaldebtnecessarytomatchCBOprojectionsandfollow

adistributiondeterminedbyactualauctionsthroughOctober2012.Thisdistributionis

thenalteredasnecessarytoextendtheaveragematurityofTreasurydebt. TheCBOs

debtprojectionsalongwiththematuritydistributionofsecuritiesauctionedinOctober

2012aresummarizedinthetablesbelow.

Year

CBOdebt

heldby

thepublic($Billion)

Buckets

October2012

Issuanceby

bucket($Billion)

Initial

sharesof

issuance

2010 9,019 1month 160 0.27

2011 10,128 3month 128 0.22

2012 11,242 6month 112 0.19

2013 11,945 1year 25 0.04

2014 12,401 2year 35 0.06

2015 12,783 3year 32 0.05

2016 13,188 5year 35 0.06

2017

13,509

7year 29 0.052018 13,801 10year 21 0.04

2019 14,148 30year 13 0.02

2020 14,512 Source: Wrightson,AuctionCalendar

2021 14,872

Source:CBO,Jan.2012TheBudgetandEconomicOutlook:FiscalYears2012to2022

6.2 Agencysecurities Theagencysecuritiesportfolioisassumedtoevolveduetoacombinationofpurchases,

sales,andprepayments.

ConsistentwiththeFOMCsstatementaftertheSeptember2011FOMCmeeting,principalpaymentsfromSOMAagencyMBSanddebtandarereinvestedinagencyMBS.

WeuseacurrentcouponmodeltoestimatethecoupononnewlypurchasedMBS

41Refertohttp://www.treasury.gov/presscenter/pressreleases/Pages/tg1349.aspxand

http://www.treasury.gov/presscenter/pressreleases/Pages/tg1665.aspx.


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securitiesbasedontheconsensuslongrunBlueChipforecastforthe10yearTreasury

rateand30yearfixedratemortgagerate,reviewedinAppendix2.

PrepaymentsonsettledagencyMBSholdingsasofOctober31,2012aregeneratedbyapplyingtherealizedprepaymentrateontheSOMAholdingsofMBSfromJune2010to

July

2011

(the

period

when

there

were

no

new

holdings

of

MBS

settling

in

the

SOMA

portfolio)onmonthlyholdingsfromSeptember2012tothefederalfundsliftoff,in

March2015. Thisprepaymentrateisnotablyfasterthanwhatwouldbepredictedusing

thestandardPSAprepaymentmodel,likelyaresultofthehistoricallylowlevelof

mortgagerates. Afterthefederalfundsrateliftsoff,wegraduallysmooththe

prepaymentratebacktothelongrunPSAmodeloverafiveyearperiod.

PrepaymentsonanticipatedfuturepurchasesofagencyMBSfollowthelongrunPSAmodelforthelifeofthesecurity.

Salesofagencysecuritiesbeginsixmonthsafterthefirstincreaseinthefederalfundsrate

and

last

for

four

years.

This

timing

is

consistent

with

that

laid

out

in

the

June

2011

FOMCMinutes;however,theexacttimingismerelyillustrativeandchosensoastobe

easilyimplementableinourprojections.

Undertheseassumptions,andgiventhematurityscheduleforagencydebtsecurities,thevolumeofsalesnecessarytoreduceholdingsofthesesecuritiestozerooverthe

fouryearperiodonlyrequiresasixmonthperiodofminimalsalesneartheendofthose

fouryears.

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PRIMER ON THE FEDERAL RESERVES BALANCE SHEET AND EARNINGS PROJECTIONS Jan 2013