“…if the Fed isn’t so all powerful, then the same unexpected external shocks that might cripple the private sector also will wreak havoc on our $4.5 trillion central bank money-manager…
…and on a federal government that is $17 trillion in debt. The latter possibility causes a lot more Americans to be stressed than does any systemic risk in their mutual-fund holdings.” Chris Cooper, Atlanta, “WSJ Letters to the Editor: Sovereign Wealth Fund or Not, The Fed Has Some Issues”
Sovereign Wealth Fund or Not, the Fed Has Some Issues
The Fed is now in a box where it may not be able to raise interest rates without creating a new budgetary and fiscal crisis.
Few would disagree with David Malpass’s thesis that the $4.5 trillion balance sheet of Treasurys and mortgage-backed securities exposes the Federal Reserve to massive interest-rate risk while creating distortions in financial markets that contribute to slow growth and a low savings rate (“The Fed is Looking Like a Sovereign Wealth Fund,” op-ed, Sept. 8). But he misses the elephant in the room.
Sovereign-wealth funds are typically created when governments have budgetary surpluses and have little or no international debt. Trillion-dollar deficits created debts that required monetization in the face of uncertain global appetite. Additionally, the Fed masked the true funding costs of deficits and debt by forcing interest rates down to artificially low levels. The Fed is now in a box where it may not be able to raise interest rates without creating a new budgetary and fiscal crisis. The increased debt-service cost from allowing interest rates to normalize would exceed the entire current defense budget.
If and when markets increasingly recognize that the U.S. borrows not only to offset deficits but also to cover a large portion of its outstanding debt-service costs, there may be a rude awakening. Thwarting this day of reckoning goes beyond the winding down of the Federal Reserve’s portfolio. It will require courage and good judgment—probably from people who haven’t been part of the problem.
Lighthouse Point, Fla.
On the same day that David Malpass makes the case that the Federal Reserve’s $4.5 trillion bond portfolio adds a distracting investment management dimension to the Fed’s challenging monetary and regulatory policy priorities, a front-page Journal article “SEC Preps Mutual Fund Rules” reports that the SEC wants investment management firms to conduct stress tests on their funds. The purpose of those tests is to determine how investment funds “would weather economic shocks such as a sudden change in interest rates.” But if mutual funds might pose a systemic risk to the financial system and the broader economy, would that not also be true of our faux sovereign-wealth fund manager inside the Federal Reserve?
Mr. Malpass prudently counsels the Fed to establish a clear portfolio wind-down process that takes it out of the sovereign wealth-fund domain. Absent that, can we who invest in mutual funds at least see the results of Federal Reserve and U.S. Treasury stress tests that show what happens if the Fed cannot contain a market panic when it actually starts to tighten monetary policy in a meaningful way? Let us see the effects of, say, a 3% increase in long-term interest rates on the Fed’s balance sheet and income statement, on Treasury’s borrowing costs and on the U.S. deficit. If the Fed can manipulate interest rates regardless of external shocks to the system, then private-sector financial firms are less likely to face a stress-inducing “black swan” event. But if the Fed isn’t so all powerful, then the same unexpected external shocks that might cripple the private sector also will wreak havoc on our $4.5 trillion central bank money-manager and on a federal government that is $17 trillion in debt. The latter possibility causes a lot more Americans to be stressed than does any systemic risk in their mutual-fund holdings.