Alyssa Anderson Federal Reserve System Council Chief
Bernd Schlusche Federal Reserve System Council Chief Economist
Zeynep Senyuz Federal Reserve System Council Deputy Director
Introduction: As part of monetary policy, the Federal Reserve (Fed) holds U.S. Treasury bonds and institutional mortgage-backed securities (hereinafter referred to as MBS Securities) in the System Open Market Account (hereinafter referred to as SOMA Account). The market value of these securities and the Fed's revenue fluctuates with interest rates. Therefore, the policy interest rates that have been continuously raised in response to inflationary pressures are expected to put downward pressure on the Fed's net income. In addition, the rise in market interest rates is expected to reduce the market value of the Fed's securities in the short term. According to a mandate from Congress, the Federal Reserve's monetary policy goal is to maximize employment and stabilize prices. The auxiliary impact of rising interest rates on the unrealized profit and loss positions of SOMA account portfolios or Fed revenue will not affect how the Fed will implement monetary policy, nor its ability to fulfill financial obligations. Compiled as follows:
In the first article, we explain the concepts related to the market value of SOMA portfolios and Fed revenues, and discuss their evolution in recent years. In the second article, there are multiple interest rate evolution paths related to different macroeconomic outcomes, and in this context we quantify the interest rate risks of the SOMA portfolio and Fed income by providing illustrative forecasts on the Fed's balance sheet and income.
1. What does the unrealized position profit and loss in the SOMA portfolio refer to? The unrealized profit and loss of a securities in the
SOMA portfolio is the difference between the market value of a securities and its amortized cost. The market value, or fair value of the Fed's securities portfolio at any time, reflects the sale price of securities in orderly market transactions. When the Fed buys a certain security at a market price, the price is usually higher or lower than its book value. People record the difference between the purchase price and face value—the premium or discount of the securities—on the balance sheet and amortize it during the period of the securities. The amortization cost of a security is defined as the purchase price minus the recognized premium or discount, which eventually converges to the book value upon maturity. The market value of US Treasury bonds and institutional MBS securities held in the
SOMA portfolio changes with interest rates. When interest rates rise, the market value of securities decreases, and unrealized positions decrease; when interest rates fall, unrealized positions increase. Figure 1 shows the 10-year Treasury yield and unrealized profit and loss at the end of the quarter in the SOMA account since 2012, showing the inverse relationship between interest rates and unrealized positions.
Figure 1 Unrealized position profit and loss in SOMA account and 10-year Treasury yield
Source: U.S. Federal Reserve, https://www.federalreserve.gov/releases/h15/; Federal Reserve joint consolidated quarterly financial reports and consolidated financial statements. The scale of position losses that have not been realized at present is due to the following two reasons: First, the interest rate is significantly higher than the interest rate at which many securities in SOMA were initially purchased, and second, the purchase of assets at the beginning of the COVID-19 pandemic led to the large size of the SOMA portfolio. Specifically, the size of the SOMA portfolio has more than doubled in two years, about $4 trillion before the pandemic and about $8.5 trillion after completing net asset purchases in March 2022.
2. What determines the Fed's revenue and remittances to the US Treasury Department?
The Fed's net income is mainly determined by the difference between the interest income generated by securities in the SOMA portfolio and the interest expenses related to its liabilities. Interest income reflects the income from assets such as repurchase agreements, discount window loans, and other credit and liquidity instruments, but these sources have insignificant revenue compared to the size of U.S. Treasury and MBS securities holdings in the SOMA portfolio. In terms of its expenditure, the Fed pays interest on some liabilities, such as reserve balances and overnight reverse repurchase agreements (ON RRP) tools, but does not pay interest on other liabilities such as circulating currency and Treasury General Accounts (TGAs).
The Federal Reserve remits all its net income to the U.S. Treasury Department, which excludes operating costs, dividend payments, and the amount required to maintain surpluses under the Federal Reserve Act. What happens if net income becomes negative? In this case, the Fed would suspend remittances to the U.S. Treasury Department, which is equal to the accumulated gap in net income and is recorded on the Fed's balance sheet as deferred assets. Inadequate net income means that remittances to the U.S. Treasury will be temporarily suspended, but this does not affect the Federal Reserve's ability to conduct monetary policy operations or fulfill its fiscal obligations.
Figure 2 Transfers and remittances to the US Treasury
Note: The light blue bar indicates the transfer of the Reserve Bank's capital surplus from the Federal Reserve to the Treasury. The transfer of the listed amounts is necessary to reduce the total reserve bank surplus to the current total surplus limit.
Source: Federal Reserve; Bureau of Economic Analysis
Although the remittances have been very high recently, as monetary policy tightening continues, the remittances are expected to fall briefly. The Federal Reserve expanded its balance sheet to cope with the new crown pneumonia, which increased the risk that the Federal Reserve would suspend remittances to the U.S. Treasury Department in the near future due to rising interest rates and increased interest expenses. However, despite the increased risk of net income becoming negative, the Fed's response to the pandemic has benefited households, businesses, the federal government and U.S. taxpayers. These measures support the smooth operation of the market, prompting credit to flow to businesses and households, ultimately achieving higher economic output and a strong labor market, which is consistent with the Federal Reserve's mission. After a period of negative net income, it has no impact on the Federal Reserve's monetary policy operations.
3. What is the relationship between unrealized positions and net income? Unrealized positions in the
SOMA portfolio are affected by interest rate fluctuations, which are mainly determined by changes in the expected path of short-term interest rates (which is determined by the actual and expected policy rates), maturity premiums, and MBS's yield spreads. Similarly, the Fed's expected net income will be affected by changes in the short-term interest rate expectation path. However, unrealized gains or losses do not flow into the Fed's net income. The market value of an individual security will converge to its face value as it approaches the maturity date, and for securities held to maturity, any gains or losses arising from interest rate fluctuations remain unrealized. Only when securities are sold and profit and loss are not realized will it become a reality, which directly affects the Fed's net income.
Although unrealized position gains and losses of the SOMA portfolio do not directly affect the Fed's net income, if a higher expected policy rate path leads to unrealized position losses, this indicates higher interest expenses in the future. Conversely, if the SOMA portfolio generates unrealized losses due to changes in term premiums, this does not mean an increase in the Fed's future interest expenditure. Finally, rising interest rates have resulted in unrealized position losses, which may also indicate an increase in interest income in the future, as the Federal Reserve reinvested the maturing U.S. Treasury bonds and purchases new securities at higher yields for reserve management purposes.
4. Final Thoughts
As interest rates are necessary to raise to cope with inflationary pressures, unrealized position losses in the SOMA portfolio may increase further, and the Fed's net income is expected to decline in the near future, which we will discuss in the second article. Even if the unrealized position losses in the SOMA portfolio are greater and the Fed's net gains are temporarily negative, the Fed will still be able to fulfill all its responsibilities. In order to achieve the goals set by Congress to expand employment and stabilize prices, the Federal Reserve will continue to formulate and implement monetary policies.
The original title of this article is "An Analysis of the Interest Rate Risk of the Federal Reserve’s Balance Sheet, Part 1: Background and Historical Perspective". This article is authored by Alyssa Anderson, Dave Na, Bernd Schlusche, Zeynep Senyuz.Alyssa Anderson is the chief of the Federal Reserve System Council, whose research areas are financial markets, banks and financial institutions, and market microstructure; Bernd Schlusche is the chief economist of the Federal Reserve System Council, whose research areas are financial markets, asset pricing, and monetary policy; Zeynep Senyuz is the deputy director of the Federal Reserve System Council, whose research areas are financial markets, macroeconomics, econometrics and statistics. This article was published on July 15, 2022.
This article is compiled: Xiong Chunting
