currency, monetary-policy, inflationThe Federal Reserve has on its balance sheet a “Maiden Lane” portfolio consisting of questionable quality mortgages. These mortgages have since taken losses reducing the equity of the Fed.
In addition, the Fed has engaged in QE1 and QE2 purchasing mortgage bonds at relatively low yields. If long-term yields rise the Fed would have to mark these securities to market at a value less than their acquired value (unless they are treated as “held-to-maturity” assets – which is doubtful since it suggests the Fed has no intention to reverse or neutralize its actions in the long-term).
What is the impact, if any, of the Fed having an “underwater” balance-sheet position as a result of losses on the asset-side of the balance sheet? Are there implications for the value of the currency in foreign exchange markets, or expected inflation?
In and of itself, the balance sheet of a Central Bank that is the sole authority over its currency, is pretty arbitrary.
However, the market may still take signals from it, about future expectations of interest rates and inflation: and at that point, it could be significant.
In the specific case that you raise, of mortgage bonds that are now underwater, that’s not necessarily going to indicate anything in particular. That’s because the Central Bank doesn’t need to take liquidity out of the market in exactly the same way that it injected it: it could remove it in entirely different ways to how it was injected. So, it could hold the bonds to maturity, or re-sell at a loss into the market: either way, as long as the market trusts that the Central Bank will, when necessary, remove excess liquidity by some means (increasing banks’ capital/reserve requirements, raising interest rates, selling other bonds it holds), then expectations of interest rates and inflation rates will remain low.
All content is licensed under CC BY-SA 3.0.