d reserves, and those reserves ultimately can be inflationary,” Reinhart said. “The chief risk of keeping the balance sheet big and raising rates is that you might not be able to raise rates successfully” because the impact would be mitigated by the effect of the extra money still sloshing around the system.
Holding the securities also could cost the Fed a lot of money.
The Fed paid some of the highest prices on record for mortgage securities, basically accepting very low rates of interest on its investments. As the economy recovers and interest rates rise, the Fed will need to accept increasingly large discounts to make the securities attractive to other investors.
David Zervos, head of global fixed-income strategy at the investment bank Jefferies & Company, estimates that the value of the portfolio will drop almost $50 billion each time interest rates increase by one percentage point.
Selling the securities at a loss would reduce the Fed’s ability to transfer profits to the Treasury Department. Large enough losses could reduce the amount of capital held by the Fed, although it can always create more money.
But perhaps the greatest risk is that investors will begin to doubt the Fed’s willingness to raise interest rates, knowing that each increase will damage its own balance sheet.
“It compromises their integrity and their inflation-fighting mandate, because fighting inflation would be a direct detriment to their portfolio,” Zervos said.
The Fed could avoid these problems by selling the securities now, before interest rates start to rise. But doing so would reverse the benefits of the original program, draining money from the economy while it still is weak. It would also fly in the face of the demands for the Fed to do more for the economy.
A fire sale also could damage the banking industry by driving down the value of the comparable mortgage securities that banks hold in large quantities.
So far the Federal Open Market Committee, comprising the board of governors and a rotating selection of presidents from the regional reserve banks, has chosen to wait.
The approach favored by most of the committee, according to the minutes of its June meeting, is to start raising interest rates before beginning to sell the securities. By waiting “until the economic recovery was well established,” the minutes said, the Fed would limit the impact of the asset sales on the broader market.