The Federal Reserve’s balance sheet is poised to soon exceed $4 trillion, prompting warnings that its record easing program is inflating asset price bubbles and drawing renewed lawmaker scrutiny just as Janet Yellen prepares to take charge.
The Fed’s assets rose to a record $3.99 trillion on Dec. 11, up from $2.82 trillion in September 2012, when it embarked on a third round of bond buying. Policymakers met Tuesday and will meet again today to decide whether to start curtailing the $85 billion monthly pace of purchases.
Among Fed officials, “there’s discomfort in the sense that the portfolio could grow almost without limit,” former Fed Vice Chairman Donald Kohn said last week during a panel discussion in Washington. Kohn said there was “discomfort in the potential financial stability effects” and added: “There’s some legitimacy in those discomforts.”
Fed Governor Jeremy Stein has said some credit markets, such as corporate debt, show signs of excessive risk-taking, while not posing a threat to financial stability. Rep. Jeb Hensarling, a Texas Republican and chairman of the House committee that oversees the Fed, last week said he plans “the most rigorous examination and oversight of the Federal Reserve in its history.”
While any effort to rewrite the law establishing Fed powers lacks support from Democrats who control the Senate, the scrutiny is undesirable for central bankers who believe “independence is priceless,” said Laura Rosner, a U.S. economist at BNP Paribas SA in New York.
“It’s not a welcome development that a lot more time and focus is spent on answering questions” from Congress, said Rosner, a former researcher at the Federal Reserve Bank of New York. Lawmakers may also use the size of the balance sheet to “draw attention to concerns they have about the Fed’s responsibilities and growing role in financial regulation.”
Chairman Ben Bernanke, whose second four-year term ends next month, has quadrupled Fed assets since 2008 with bond purchases intended to lower long-term borrowing costs and reduce unemployment. Vice Chairman Yellen, who may win Senate confirmation this week to replace Bernanke, has been a supporter of the policy.
The Fed has said it will keep buying bonds until the outlook for the labor market has “improved substantially.” Thirty-four percent of economists surveyed by Bloomberg Dec. 6 predicted the Fed will start reducing purchases this month, while 26 percent forecast January and 40 percent said March.
The Fed’s balance sheet exceeds the gross domestic product of Germany, the world’s fourth-largest economy. It’s enough to cover all U.S. federal government spending for more than a year. It could pay off all student and auto loans in the country with $2 trillion to spare, Fed data show. The central bank’s assets are set to exceed the $4.1 trillion held by Black Rock Inc., the world’s largest asset manager.
The third round of quantitative easing probably will total $1.54 trillion before it ends, bringing the balance sheet to $4.36 trillion, according to economists in the survey.
“This is a stimulus of the first order. It’s just unprecedented,” Alabama Republican Sen. Richard Shelby said in an interview last week. “The Fed is an independent body, but we can point out what they’re doing.”
Jeffrey Lacker, president of the Richmond Fed and a critic of the Fed’s bond buying, said in a Dec. 9 speech he expects the Fed policymakers to discuss reducing purchases at this week’s meeting. Adding to the balance sheet “increases the risks” associated with exiting stimulus, he said.
Shelby said he sees “a real risk” the balance sheet will ignite inflation. So far, there’s little sign that’s happening: a measure of prices watched by the Fed rose 0.7 percent in October from a year earlier, below the central bank’s 2 percent target and the least in four years.
At 22 percent of the $16.9 trillion U.S. economy, the balance sheet is surpassed by those of other major central banks as a percentage of gross domestic product, according to third-quarter data compiled by Haver Analytics in New York. In the euro zone, the figure is 24 percent, and in Japan, it’s about 44 percent.
The Fed and other U.S. banking regulators have said they want to crack down on underwriting standards in the market for high-risk, high-yield loans.
Nonbank lenders such as mutual funds, hedge funds and pools of collateralized loan obligations, bought $630 billion of the loans this year, surpassing the 2007 peak of $581.5 billion, according to data compiled by Bloomberg.
Sales of high-yield, high-risk bonds soared to an annual record of $373.2 billion this year, data compiled by Bloomberg show. That compares with $149.2 billion in 2006, the year before the start of the credit crisis.
Potential losses on the Fed’s investments are also cause for concern and “something we will be watching,” Rep. John Campbell, a California Republican who leads the House Financial Services subcommittee on monetary policy and trade, said in February.
The Fed sent a record $88.4 billion to the Treasury in 2012 and $75.4 billion in 2011, up from $31.7 billion in 2008. Most of the income was from interest on assets bought under the quantitative easing program.
The risk for the Fed is that rising interest rates reduce the value of its bond holdings, potentially causing losses if the central bank had to sell the securities back into the open market.
“Losses are dangerous for the Fed from a political perspective because they would be a risk to its independence,” said Roberto Perli, a partner at Cornerstone Macro LP in Washington.
Business, Pages 25 on 12/18/2013