The net income the Federal Reserve Bank reported on Tuesday — $52 billion, the highest in all the Fed’s 96 years — is likely to plateau, or even evaporate, next year. The record profits mostly result from interest payments on bonds it purchased as part of a 2009 purchase program scheduled to end on March 31.
In January 2009, the Fed announced a $1.25 trillion mortgage-backed security purchase program aimed at artificially creating demand for bonds when markets were weak. The Fed reasoned that if it didn’t start buying when others weren’t, mortgage rates would spike and home prices would fall. In essence, the Fed printed $1.25 trillion during the last year to ensure homeowners’ confidence and free-flowing credit.
The Federal Open Market Committee, which is responsible for such policies at the Fed, has released an official statement saying the program will end in March. But markets may not be capable of filling the vacuum and the Fed knows it.
“I expect them to extend it,” the director of financial regulation studies at the Cato Institute, Mark Calabria, who spent six years on the Senate Banking Committee, said. “There will be tremendous political pressure from the realtors, home builders and mortgage bankers – and the administration wants to do whatever it can to prop up home prices.”
Some bond traders expect the program to be extended, pointing to a caveat at the end of the statement that reads: “The committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.” A quarter of of Blue Chip economists believe the program will be extended.
The Fed isn’t known for making money the old-fashioned way (i.e., earning it). It usually “makes” money by printing it to control the money supply and interest rates. Last year’s move helped stabilize the economy, but some bond traders and economists have expressed nervousness that more than $100 billion in monthly bond purchases may suddenly vanish. They imagine that regular banks will step in to prop up demand so bond prices don’t drop.
Even if the Fed abruptly ends its purchase program, experts say it’s not necessarily reason for panic. “It’s an open question as to what kind of interest rate increase we’ll see, but I don’t think we’ll see them skyrocket,” Calabria said. “It would be under a 1 percent increase.”
The Fed has doubled its balance sheet in the last year, to $2.2 trillion, and it looks a lot more like a regular private bank, complete with bundles of mortgage-backed securities in its portfolio.
When the Fed stops buying bonds by the billions, the value of the bonds it already owns will drop. It’s a simple matter of supply versus demand: fewer purchasers for a product, and the product’s value declines. It puts the Fed in a tricky situation. In addition to aiming for low interest rates, it may extend the program to help buoy the value of the mortgage-backed assets already on its balance sheet. While traditionally the Fed is not in the business of getting a return on its investments, its long-term holdings are now at odds with its role in setting short-term interest rates.