The Federal Reserve (Fed) and the U.S. Congress are on a collision course. The release of FOMC minutes from its January meeting underscores this. As the economy slowly improves and the unemployment rate declines, eventually the conditions will be appropriate for exiting quantitative easing and returning the federal funds rate to a non-emergency level.
- The Fed will be increasing the federal funds rate.
- The Fed will be selling Treasury securities into a rising rate environment, which may make yields in the long-end of the curve rise disproportionately faster.
- As rates rise, the Fed will take unrealized losses on its existing portfolio of Treasury securities and mortgage-backed securities, meaning the Fed will stop contributing any net profits to the US Treasury, which have averaged about $80 billion annually recently.
From Congress’ point of view, the unintended consequences of the Fed’s exit from its massive quantitative easing programs will exacerbate the budget deficit in several ways.
- Interest expense on the outstanding government debt might rise from 1.4 percent in 2012 to 3.0 percent of GDP by 2018, depending on how fast rates rise.
- The Fed’s net earnings contribution to deficit reduction could go to zero as soon as 2014 or 2015.
- The US economy will have to overcome drag from both fiscal austerity and rising bond yields made worse by the Fed’s selling of Treasury securities.
- The complex process of reforming the housing agencies, Freddie Mac and Fannie Mae, could be negatively impacted if the Fed decides to sell any of its trillion dollar mortgage-backed securities and agency securities portfolio.
From a political perspective, the Fed is likely to become a focal point of the deficit reduction debate during the 2014 Congressional election. There will be a new leader at the Fed after Ben Bernanke’s term ends in January 2014. It will fall to the new chairman or chairwoman to be the apologist to Congress for the unintended consequences of massive quantitative easing.