The Federal Reserve has purchased a large amount of longer-term bonds since December 2008. While these purchases have helped support a strengthening economy, the Fed’s resulting financial position may incur significant declines in bond values and net income when interest rates rise. However, analyzing a range of possible future interest rate scenarios—and their associated probabilities—shows that potential losses associated with these declines are very likely to be manageable.
Over the past six years, the Federal Reserve has provided additional monetary stimulus to spur economic growth and avoid price deflation by conducting several rounds of large-scale bond purchases—commonly known as quantitative easing. Through this program, the Fed has accrued a portfolio of longer-term securities several times larger than it was before the start of the financial crisis. This enormous size has prompted worries that the Fed could incur significant financial losses when interest rates rise. Indeed, the minutes of the December 2013 FOMC meeting noted “concerns about potential reputational risks to the Federal Reserve arising from any future capital losses.â€
To assess the Fed’s portfolio risks, it is crucial to quantify them. Recent research by Carpenter et al. (2013) and Greenlaw et al. (2013) has generated detailed projections of the market value and cash flow of the Fed’s assets and liabilities under a few specific interest rate scenarios. Their projections are similar in spirit to the stress tests that large financial institutions conduct to gauge whether they have enough capital to endure adverse economic events. These projections do not place probabilities on the alternative interest rate scenarios but simply consider the repercussions of, say, shifting the level of the entire yield curve up or down from its baseline projection by a percentage point. Yet, the probability that a specific outcome will occur is also of great interest to policymakers. Attaching likelihoods to the alternative scenarios—or more generally, looking at the entire probability distribution of forecasts—results in what we term “probability-based†stress tests.
In this Economic Letter, we describe a probability-based stress test of the interest rate risk the Fed faces (see Christensen, Lopez, and Rudebusch 2013). Looking at projections of the U.S. Treasury yield curve, we assess the probabilities of key risk events, such as significant declines in the value of the Fed’s holdings of Treasury securities or in its income. We also consider how likely it is that these risky events would substantially reduce the Fed’s remittances to the Treasury. Using data through the end of 2012, we judge that adverse outcomes that could cause serious concerns for the Fed appear quite unlikely; this holds true using data through the end of 2013 as well (not shown). For example, there is only a remote chance that declines in Treasury bond prices could lead to mark-to-market losses on the Fed’s portfolio. Such low probabilities for these adverse outcomes should assuage concerns about the Fed’s portfolio holdings and income.
