Fed should stop sending profits to Treasury, economist argues

SAN FRANCISCO, June 12 Thu Jun 12, 2014 6:37pm EDT

SAN FRANCISCO, June 12 (Reuters) - The U.S. Federal Reserve should suspend payments to the Treasury to avoid a potential cash crunch when the time comes to raise interest rates, according to former Richmond Fed policy adviser Marvin Goodfriend.

Such a reversal in policy is critical to protecting the Fed's inflation-fighting credibility, Goodfriend said in an interview Thursday, because otherwise the central bank will find itself needing to print money to pay for its obligations as it raises interest rates, an untenable situation in his view.

"It's not good idea for a central bank to ever put itself in the position of having to create money to stabilize the value of money against inflation," said Goodfriend, now an economics professor at Carnegie-Mellon University. "You are throwing fuel on the fire."

The U.S. central bank has sent about $320 billion to the Treasury since 2010. The money comes from interest earned on the Fed's massive portfolio of bonds acquired in its ongoing effort to push down borrowing costs and boost the economy.

The Fed pays for those bond purchases by creating reserves in the accounts of banks that hold funds at the Fed. When the time comes to raise rates from their current near-zero level, the central bank plans to prevent those reserves from flooding back into the financial system by raising the rate of interest it pays on them.

Economists have previously flagged the possibility that doing so could reduce the amount of money the Fed sends to the Treasury, while boosting the Fed's payments to banks, creating what some central bankers have called an "optics" problem.

Goodfriend points to another danger: the possibility that if rates rise high enough, to 3.75 percent, the Fed will no longer make enough money on its interest income to cover its rising interest payments to banks.

The issue is not potential insolvency; the Fed can print money by creating reserves. The issue, according to Goodfriend, is in creating new reserves in order to pay banks interest on existing reserves. "The credibility of the Fed's anti-inflation policy would be jeopardized," he said in a paper presented at a Bank of Japan conference late last month.

The Fed could have avoided the problem, Goodfriend said, if it had recognized its bond-buying stimulus for what it is - a massive "carry trade" by which the Fed created reserves to finance its purchases of bonds, which generate higher interest.

Firms running such a strategy typically retain profits made at the outset to cover the losses they will likely encounter when the trade is eventually unwound, Goodfriend explained. The Fed, however, has been transferring its profits to the Treasury, leaving it with a too-thin cushion against eventual losses, he said.

If the Fed starts retaining its earnings now, he said, it could build a $60 billion buffer by next March, enough to make a meaningful difference in preventing a cash crunch. (Editing by Eric Walsh)