By Pedro da Costa and Ann Saphir - WASHINGTON/CHICAGO (Reuters) - The U.S. Federal Reserve's journey to the outer limits of monetary policy is raising concerns about how hard it will be to withdraw trillions of dollars in stimulus from the banking system when the time is right.
While that day seems distant now, some economists and market analysts have even begun pondering the unthinkable: could the vaunted Fed, the world's most powerful central bank, become insolvent?
Almost by definition, the answer is no.
As the monetary authority, the central bank is the master of the printing press. It can literally conjure up money at will, and arguably did exactly that when it bought about $2 trillion of mortgage-backed securities and U.S. Treasuries to push down borrowing costs and boost the economy.
The Fed's unorthodox steps helped it generate record profits in 2010, allowing it to send $78.4 billion to the U.S. Treasury Department. But its swollen balance sheet leaves the central bank unusually exposed to possible credit losses that could create a major headache at a time of increasing political encroachment on the Fed's independence.
Asked about the issue of potential losses during congressional testimony on Friday, Fed Chairman Ben Bernanke suggested the risks were minimal. If liabilities on the Fed's balance sheet were to exceed its assets, it would only be so because of rising interest rates in the context of a thriving economy, he suggested.
"Under a scenario in which short-term interest rates rise very significantly, it's possible that there might come a period where we don't remit anything to the Treasury for a couple of years. That would be I think a worst-case scenario," Bernanke said. Customarily, the Fed submits surplus profits from its operations back to the Treasury's coffers.
But the Fed's newfangled policy steps and the potential for credit losses raises, for some experts, the prospect that the Treasury may actually be forced to "recapitalize" the Fed -- economist-speak for what others might call a bail-out.
That would be a strange role reversal given the Fed's efforts to ease monetary policy by buying the Treasury's debt, and it could raise a political firestorm from lawmakers who believed all along the Fed was putting taxpayer money at risk.
A PAUPER ON PAPER
Varadarajan Chari, an economics professor at the University of Minnesota and a consultant to the Minneapolis Fed, says that at some point during its exit from easy monetary policies, the Fed actually may go broke -- at least on paper.
"The most obvious exit strategy is, when inflation starts to pick up, to stop and reverse asset purchases," he said. "That's likely to include requiring the Fed in an accounting sense to see a significant accounting loss."
The Fed now holds just over $1 trillion in Treasuries, Chari noted, and if inflation rose by a couple of percentage points, it would dent the value of those holdings by about 10 percent, leaving the Fed with a $100 billion loss.
"I'm sure it will have some negative political fallout," Chari said. "But not economic consequences. Their ability to print money means it (insolvency) doesn't mean anything."
Many economists argue that the potential cost to the taxpayer from the Fed's policies is far smaller than the threat of a prolonged period of economic stagnation that would result from a less proactive approach.
With the U.S. unemployment rate at 9.4 percent and only tentative signs that businesses are beefing up hiring, Fed officials, including Chairman Bernanke, see a duty to prevent a further deterioration of economic conditions -- and have signaled a readiness to use all the tools at their disposal.
Last November, as the economic recovery appeared to falter, the Fed said it would buy a new round of $600 billion in Treasury securities through June of this year. That's on top of the $1.7 trillion in Treasuries and mortgage-backed securities it had purchased in response to the financial crisis.
Still, the pitfalls of the Fed's approach are almost as numerous as the lending facilities it undertook to stem the crisis. Perhaps most daunting, the Fed's purchases of Treasury debt and mortgage-backed securities have effectively turned it into a mammoth investor -- a thoroughly undiversified one.
"The biggest risk is losses on its portfolio on long-term debt if inflation rises," said Alan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh.
QUANTITATIVE TEASING
That threat is already apparent in the Fed's latest round of bond buying, or so-called quantitative easing. According to calculations by Reuters Insider credit analyst Ed Rombach two weeks ago, the average duration of the Fed's new portfolio of bonds is just under 5 years, and every 1-basis-point rise in 5-year to 6-year Treasury yields results in a loss of about $65 million.
The Fed is sitting on paper losses of about $2.3 billion on the purchases of U.S. Treasuries it made from November 12 until late last week, according to an analysis by Reuters Insider.
The Fed is also vulnerable to losses through its so-called Maiden Lane portfolios, a collection of investments it acquired when it brokered J.P. Morgan Chase's takeover of a floundering Bear Stearns and bailed out failed insurer AIG.
The portfolio will likely generate losses, according to many analysts. Still, the total Maiden Lane portfolio amounts to just $66 billion, a small slice of the Fed's growing pie of securities.
For most Fed officials, a concern over credit losses would be a luxury compared with the risk they see as predominant: that the economy will not grow quickly enough to return more than 14 million unemployed Americans to work, and inflation so low that it leaves the country exposed to possible deflationary shocks.
"The risks are worthwhile given that the economy would be in the toilet if the Fed never did anything to expand its balance sheet," said Michael Feroli, chief economist at JP Morgan and a former New York Fed staffer.
Feroli does not believe asset sales will be a primary avenue for the Fed's exit. Indeed, Bernanke appears to think the ability to raise interest rates on bank reserves might prove the most effective way to withdraw stimulus. But even that tool is not without its mechanical difficulties.
The problem lies in the basic workings of fixed income. By definition, bond prices decline when their yields or interest rates go up. That means that as the economy recovers and pushes inflation higher, the Fed will move to increase interest rates, pushing down the value of its giant bond portfolio.
"What would the international reaction be if the Fed suddenly had to go and be recapitalized?" said Bob Eisenbeis, chief monetary economist at Cumberland Advisors and a former head of research at the Atlanta Fed. "I don't think that would bode well for Treasuries, or for the dollar, or anything else. It would be embarrassing."