The world is waiting for the Federal Reserve’s Open Market Committee to begin raising interest rates. But there’s another important issue waiting offstage: The Fed says it will adjust its bloated balance sheet after interest rates begin to rise. But when, and what does that really mean?
 
Quantitative easing resulted in the purchase of $4.2 trillion of mortgage-backed and Treasury securities and the creation of $2.6 trillion of excess reserves.
 
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Illustration: Carl Wiens for Barron?s
 

Like everyone else in the world of finance, the Fed needs interest income from its securities portfolio to pay for the costs of interest on excess reserves, its new monetary tool.
 
As the FOMC begins raising rates, the costs of its new tool will rise simultaneously. When the FOMC increases the federal-funds rate to 3.75% by increasing the interest rate paid on excess reserves to 3.75%, that will usurp all of the Federal Reserve’s earnings, and our central bank will become a borrower from the Treasury, rather than a provider of funds. This would be a huge embarrassment to the Fed because it has credited the Treasury with its annual earnings for decades. Those earnings credits are now $100 billion annually because of the bank’s unusually large securities portfolio—and the Treasury has become accustomed to this windfall.
 
So the first order of business for the FOMC is to get the costly excess reserves off the Fed’s balance sheet so it can revert to its traditional means of controlling rates through the purchase and sale of short-term Treasuries. Those trades are far less costly.
 
In order to do this, the FOMC must first re-establish the fed-funds market as our banking industry’s primary source of liquidity. Banks now rely on excess reserves for this purpose because the FOMC collapsed the fed-funds market with its prolonged near-zero interest-rate policy. Moreover, banks are able to purchase funds in the short-term Treasury market from participants ineligible to hold reserves and willing to accept less than the fed-funds rate when selling funds and to arbitrage these in their reserve accounts.
 
Step No. 1 in re-establishing the fed-funds market is initiating rate increases to give the market room to operate. Somewhere between zero to 0.25%, where the fed-funds rate is now, and 3.75%, the FOMC probably will revert to relying on the purchase and sale of short-term Treasuries to control interest rates. Then the FOMC can cleanse the Fed’s balance sheet of all excess reserves simply by paying no interest on them once again.
 
A tricky part in this transition is maintaining the availability of an effective monetary tool, so that the FOMC doesn’t lose control of interest rates and also doesn’t create problems for banks.
 
If, tomorrow, the FOMC stopped paying interest on excess reserves, it would lose its monetary tool and thus control of interest rates. Banks would be required to redeploy $2.6 trillion into an economy awash in liquidity, further complicating the transition.
 
In addition to the FOMC’s forcing banks to rely on their $2.6 trillion of excess reserves for liquidity purposes, the Fed’s regulatory actions since the crisis of 2008 have been directed at filling banks’ balance sheets with capital and liquidity and promulgating rules, regulations, and stress tests to avoid a recurrence of a taxpayer bailout. But the Fed also effectively tightened lending standards, dampening lending and deployment of banks’ excess liquidity.
 
THE BALANCE SHEETS of our large corporations are also awash in liquidity—and they mostly are sitting on their trillions of dollars of cash or using it to buy back shares, rather than investing in new ventures that would promote growth.
 
But there is little the Fed can do about getting corporations to deploy this liquidity because this requires fiscal-policy initiatives that we haven’t seen since the Washington gridlock commenced six years ago. It would also require the monetary authorities in Europe and Japan to stimulate growth in their stagnant economies.
 
The Fed’s recent announcement increasing the dollar amount of reverse-repurchase transactions in which it will participate seems intended to position the FOMC to deal with the transition problems in moving back to reliance on trading short-term Treasuries as its means of controlling rates. Doing more reverse-repurchase transactions will provide the FOMC with additional capability to push up the interest rate paid in the market for reverse repos, and thus provide upward pressure on the fed-funds rate.
 
Disposition of the Fed’s security portfolio poses a different set of problems. It will have to stop reinvesting principal repayments and let the assets run off their balance sheet. Selling them would create mark-to-market problems because the Fed has only $57 billion in capital to cushion losses that would result from portfolio devaluation because of rising rates. GAAP, however, doesn’t require a markdown of securities if they are held in a portfolio until fully paid down.
 
Meanwhile, numerous legislative proposals to audit the Fed are lingering, including one for a centennial commission to review the past 100 years of monetary policy and make recommendations on redesigning the Fed—while Congress awaits receipt of the results of criminal and internal investigations regarding allegations of unauthorized disclosure of confidential FOMC information.
 
Attempts to challenge the Fed’s political independence have been going on for decades, but not of the scope and depth reflected by these recent actions. As more becomes known about how the FOMC has painted itself, and the nation, into a corner with its unconventional monetary policy, such legislative interest and concern will intensify.
 
It’s time for the Fed to batten down the hatches and garner all of the political support it can to survive this onslaught. 
 
 
JIM KUDLINSKI was director of the Division of Federal Reserve Bank Operations and an official of the Fed’s board of governors from 1971 to 1981. He is author of the 2014 book The Tarnished Fed. He lives in Overland Park, Kan.