Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Aairs Federal Reserve Board,

Washington, D.C.

The Federal Reserves Balance Sheet and Earnings: A primer and projections

Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, Daniel W. Quinn, and Alexander H. Boote
2013-01

NOTE: Sta working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research sta or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

TheFederalReservesBalanceSheetandEarnings Aprimerandprojections1
SethCarpenter,JaneIhrig,ElizabethKlee,DanielQuinn,andAlexanderBoote2 January2013 Abstract Overthepastfewyears,theFederalReservesuseofunconventionalmonetarypolicy toolshasledittoholdalargeportfolioofsecurities.Theassetpurchasesareintendedtoput downwardpressureonlongerterminterestrates,butalsoaffecttheFederalReservesbalance sheetandincome.WebeginwithaprimerontheFederalReservesbalancesheetandincome statement.Then,wepresentaframeworkforprojectingFederalReserveassetsandliabilities andincomethroughtime. TheprojectionsarebasedonpubliceconomicforecastsandannouncedFederalOpen MarketCommitteepolicyprinciples.Theprojectionsimplythatforthenextseveralyears,the FederalReservesbalancesheetremainslargebyhistoricalstandards,andearningsremain high.UsingtheFOMCsstatedexitstrategyprinciplesandtheBlueChipfinancialforecastsof thefederalfundsrate,theprojectionshavetheFederalReservesportfoliobeginningto contractin2015.Theportfolioreturnstoamorenormalsizeinearly2018or2019,andreturns toamorenormalcompositionayearthereafter.TheprojectionsimplythatFederalReserve remittancestotheTreasurywilllikelydeclineforatime,andinsomecasesfalltozero.Once theportfolioisnormalized,however,earningsareprojectedtoreturntotheirlongruntrend. Onnetovertheentireperiodofunconventionalmonetarypolicyactions,cumulativeearnings arehigherthanwhattheylikelywouldhavebeenwithouttheFederalReserveassetpurchase programs. Toillustratetheinterestratesensitivityoftheportfolioandearnings,weconsider scenarioswhereinterestratesare100basispointshigheror100basispointslowerthaninthe baselineprojections.Withhigherinterestrates,earningstendtofallabitmoreand remittancestotheTreasurystopforalongerperiodthaninourbaselineprojections,whilewith lowerinterestratesearningsareabitlargerandremittancescontinuethroughoutthe projectionperiod.Witheitherinterestratepath,earningsfollowthesamegeneralcontouras inthebaselineanalysis.

ThispaperisanexpansionoftheTheFederalReservesBalanceSheet:APrimerandProjections,FEDSWorking Paper#201256. 2 TheauthorsarestaffeconomistsandresearchassistantsintheDivisionofMonetaryAffairs,BoardofGovernors oftheFederalReserveSystem,Washington,D.C.20551U.S.A.WethankJamesClouse,BillEnglish,MichelleEzer, DonHammond,LawrenceMize,JulieRemache,ViktorsStebunovs,LisaStowe,JeffMoore,AriMorse,andBrett Schulteforthoughtfuldiscussionsandassistance.Theviewsinthispaperaresolelytheresponsibilityofthe authorsandshouldnotbeinterpretedasreflectingtheviewsoftheBoardofGovernorsoftheFederalReserve SystemorofanyotherpersonassociatedwiththeFederalReserveSystem.

1 Introduction
Inresponsetothefinancialcrisisthatbeganin2007andthesubsequentrecession,theFederal Reservehasbeenemployingavarietyofnontraditionalmonetarypolicytools.Theuseofthese toolshassignificantlyaffectedthesizeandcompositionoftheFederalReservesbalancesheet, aswellasitsearnings.3TheFederalReservesactionshavegarneredpublicattention,and FederalOpenMarketCommittee(FOMC)membershaveoftendiscussedinspeechesandpublic forumshowtheiractionshaveinfluencedthesizeofthebalancesheet.Theexpansionofthe balancesheethasalsopromptedquestionsabouttheinterestrateriskoftheportfolio.Using publicallyavailabledataandFederalReserveBankaccountingconventions,weprojectthe FederalReservesbalancesheetandincomethrough2025.Theprojectionsincludealternate scenariosformonetarypolicyin2013andaroughgaugeoftheinterestrateriskoftheFederal Reservesbalancesheet. AsshowninFigure1,through2007,thelargestassetitemoftheFederalReserve(reported abovethehorizontalaxis)wasTreasurysecurities.Thelargestliabilityitem(reportedbelow thehorizontalaxis)wasFederalReservenotesthatis,currency.Priortothefinancialcrisis, theFederalReservesbalancesheetgrewatafairlymoderatepace,withtheOpenMarketDesk (Desk)attheFederalReserveBankofNewYorkpurchasingadditionalTreasurysecurities roughlyonpacewiththeexpansionofcurrencyandFederalReserveBankcapital. Atthestartofthefinancialcrisis,theFederalReservesbalancesheetbegantoexpandata fasterpace,largelybecauseofanincreaseoflendingthroughtheliquidityandcreditfacilities thatwereestablishedatthattime.4Theseextensionsofcreditexpandedtheassetsideofthe balancesheet,whileasubstantialportionofthematchingincreaseontheliabilitysideofthe

TheFederalReservesbalancesheetispublishedeachThursdayintheH.4.1statisticalrelease,availableat http://www.federalreserve.gov/releases/h41/.TheFederalReservesincomestatementisfoundintheFederal ReservesAnnualReportavailableathttp://www.federalreserve.gov/publications/annualreport/default.htm. 4 ForadiscussionoftheFederalReservescreditandliquidityfacilities,see http://www.federalreserve.gov/monetarypolicy/bst.htm.

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balancesheetwasinreservebalances.5Theseliquidityfacilitiesbegantowinddownasthe FederalReservesassetpurchaseprogramsstartedtorampup.Asaconsequenceoftheasset programs,theFederalReservesSystemOpenMarketAccount(SOMA)portfoliothatis,its holdingsofsecuritiesmorethantripledfrom2008totoday,andinDecember2012exceeded $2.6trillion. AssociatedwiththesubstantialchangeintheFederalReservesbalancesheethasbeena notablechangeintheFederalReservesnetearnings.TheFederalReservegeneratesa substantialportionofitsincomefromtheinterestearningassetsheldbytheFederalReserve Banks,particularlyintheSOMAportfolio.FederalReserveexpensesincludeoperating expensesnecessarytocarryoutitsresponsibilities,aswellasinterestexpenserelatedto certainliabilitiesoftheFederalReserveBanks;currently,thelargestinterestexpensestems fromreservebalances.FederalReserveincome,lessexpenses,plusprofitandlossonsalesof securities,isreferredtoasnetincome.TheFOMCpursuesitsstatutorilymandatedgoalsof fullemploymentandstableprices,andtheresultingnetincomeissimplyabyproductofthe actionstaken.TheFederalReserveisstatutorilyrequiredtopaydividendsoncapitalpaidin. UnderBoardofGovernorspolicy,afterretainingsufficientearningstoequatesurpluscapitalto capitalpaidin,theFederalReserveBanksremitresidualnetincometotheU.S.Treasury. AsaresultoftheFOMCsactionstoachieveitsmonetarypolicygoals,theFederalReserve recentlyhasbeenremittingmoreincometotheTreasurythanwashistoricallythecase.As showninFigure2,interestincomehasincreasednotably,particularlytheportionattributable totheSOMAholdingsofagencyMBS.Moreover,interestincomehasrisensignificantlymore thaninterestexpenseand,asaresult,remittancestotheTreasuryhavegrownsubstantiallyin recentyears,fromroughly$25billionperyear,onaverage,from2001to2007,toalmost$80 billionin2010and2011,andtonearly$90billionin2012,asshowninFigure3.And,although someattentionhasbeenfocusedonthechangeinthebalancesheetandthepotentialinterest
Throughoutthispaperthephrasereservebalanceswillbeusedtodenotedepositsofdepositoryinstitutions thatarenotintermdeposits.Thismeasureisreportedintables8and9oftheH.4.1statisticalreleaseas Deposits,Otherdepositsheldbydepositoryinstitutions.Thisconceptisslightlydistinctfromtheconceptof reservebalancesreportedintable1oftherelease.Thatconceptexcludes,amongotheritems,contractual clearingbalances.
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rateriskthattheFederalReservehasincurred,infact,theFederalReservessecuritiesportfolio currentlyhasanunrealizedgainpositionofroughly$249billionasofSeptember2012.6 ThispaperdescribesaframeworkforconstructingprojectionsoftheFederalReservesbalance sheetandincomestatementunderavarietyofpossiblescenarios.Theseprojectionsarenot forecasts.Aswillbecomeclear,theprojectionsdependcriticallyonawholehostof assumptionsaboutfuturemonetarypolicydecisions,financialmarketdevelopments,andother issues.Theassumptionsandprojectionsofeachofthosefactorsimplyapathforthebalance sheetandremittancestotheTreasury.Theseprojectionsillustratehowthevariousfactorsthat affectthebalancesheetandincomeoftheFederalReservedosodynamically.Ofcourse,other assumptionsareplausible,andtheaimofthispaperistoillustratehowonecouldtakevarious assumptionstocreateprojections. Webaseourmodelingonthreekeyinputs.First,westartwiththeFederalReservesbalance sheetasofOctober31,2012andmodelassetprogramsannouncedthroughDecember2012. Inparticular,theFOMCsDecember2012statementindicatedthat: Tosupportastrongereconomicrecoveryandtohelpensurethatinflation,overtime, isattheratemostconsistentwithitsdualmandate,theCommitteewillcontinue purchasingadditionalagencymortgagebackedsecuritiesatapaceof$40billionper month.TheCommitteealsowillpurchaselongertermTreasurysecuritiesafterits programtoextendtheaveragematurityofitsholdingsofTreasurysecuritiesis completedattheendoftheyear,initiallyatapaceof$45billionpermonth.[]The Committeewillcloselymonitorincominginformationoneconomicandfinancial developmentsincomingmonths.Iftheoutlookforthelabormarketdoesnotimprove substantially,theCommitteewillcontinueitspurchasesofTreasuryandagency mortgagebackedsecurities,andemployitsotherpolicytoolsasappropriate,untilsuch improvementisachievedinacontextofpricestability. Theprogramoutlinedinthisstatementishighlyconditionalonmacroeconomicoutcomes. Modelingthejointmacroeconomicandmonetarypolicyinteractionsisoutsidethescopeofthe presentpaper.However,weconsiderthebalancesheetandincomeeffectsofthreealternative additionalassetpurchaseamounts:noadditionalpurchases;$500billioninadditional

ThequarterendmarketvalueoftheSOMAportfolioispublishedintheFederalReserveBanksCombined QuarterlyFinancialReports,availableathttp://www.federalreserve.gov/monetarypolicy/bst_fedfinancials.htm#quarterly.

purchasesin2013atapaceof$45billionpermonthofTreasurysecuritiesand$40billionper monthofagencyMBS;and$1trillioninadditionalpurchasesin2013atapaceof$45billionper monthofTreasurysecuritiesand$40billionpermonthofagencyMBS.BecausetheFederal Reservehaspurchasedsecuritiesin2013,thefirstscenarioisnotpossible,butitnevertheless providesagoodbenchmarkforcomparingtheoutcomesofthedifferentscenarios. Second,weinterprettheminutesoftheJune2011FOMCmeetingtoputsomestructureona plausibleexitstrategyfrommonetarypolicyaccommodation.Theseexitprinciplessuggesta sequenceofmonetarypolicyactions,startingwithallowingSOMAholdingstomatureandroll offtheportfolio.Inourprojections,weassumethisisthefirststeptoexitthecurrent unconventionalmonetarypolicyaccommodation.ThenweassumethattheFOMCbeginsto raisethetargetfederalfundsrate,andfinallyitsellsSOMAassets,inordertonormalizethe sizeandcompositionofthebalancesheetwithinanumberofyears. Finally,werelyontheDecember2012BlueChipEconomicIndicatorsforecastfornominalGDP growthandinterestrates.TheBlueChipEconomicIndicatorsisaconsensusforecastbasedon asurveyofprofessionalforecasters;weusethemeanoftheforecastforourselectedeconomic variablesforguidancewiththeirprojectedpaths.Weassumethatthetimingofthevarious elementsoftheexitstrategyistiedtothetimingoftheliftoffofthefederalfundsrate.Allof theseinputsarepubliclyavailableandinnowayrepresentaforecastfromtheFederalReserve oritsstaff. Keyfindingsusingtheassumptionsnotedabovearethefollowing.First,theprojectionsyielda FederalReservebalancesheetthatremainslargebyhistoricalstandardsforanumberofyears. Inparticular,theSOMAportfolioexpandswithassetpurchasesin2013andthencontractsat onlyaslowpacethroughthemediumterm,reflectingthefactthatasofDecember2012,the FOMCsuggestedthatconditionswillmostlikelywarrantkeepingthefederalfundsrateat exceptionallylowlevelsforsometime.7Undertheassumptionofnofurtherassetpurchasesin
TheDecember2012FOMCstatementexplicitlystatedthattheCommitteedecidedtokeepthetargetrangefor thefederalfundsrateat0to1/4percentandcurrentlyanticipatesthatthisexceptionallylowrangeforthefederal fundsratewillbeappropriateatleastaslongastheunemploymentrateremainsabove61/2percent,inflation betweenoneandtwoyearsaheadisprojectedtobenomorethanahalfpercentagepointabovetheCommittees
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2013,theSOMAportfoliodoesnotreturntoamorenormalsizeuntilearly2018.Underthe assumptionofanadditional$1trillioninassetpurchasesin2013,theportfolioreturnstoa morenormalsizeinearly2019.Ineithercase,thecompositionoftheportfoliodoesnotreturn tonormaluntilaboutayearafterthesizenormalizes. Second,theprojectionsimplythatremittancestotheTreasurycontinueatarobustpace through2015.However,whenthefederalfundsrateincreasesandsecuritiessalescommence, remittancesmightbehaltedforafewyears,reflectingtheelevatedinterestexpenseonreserve balancesandcapitallossesassociatedwithsalesofMBS,bothofwhichoffsettheinterest incomefromtheportfolio.FederalReserveBankaccountingrulesstipulatethatwhenincome isnotsufficienttocoverexpenses,remittancestotheTreasurycease,andtheFederalReserve booksadeferredasset.8Inthescenariowithnoadditionalpurchasesin2013,theprojection suggestsalowlevelofremittancesforafewyears,butnodeferredasset.However,larger amountsofsecuritiespurchasedin2013increasethelikelihoodofadeferredasset.The projectionwith$1trillionofadditionalpurchaseshasadeferredassetforabout4years,witha peakvalueof$45billion.Itisimportanttonotethatadeferredassetwouldnothaveany implicationsfortheFOMCsabilitytoconductmonetarypolicy,butremittancestotheTreasury wouldhalt.Thatsaid,projectionsforcumulativeremittancesfrom2009and2025are projectedtobeatleast$720billion,orover$40billionperyear,substantiallymorethanthe roughly$25billionperyearremittedpriortothefinancialcrisis.Thislongerrunperspectiveon remittancesisimportant,becausetheremittancesfluctuatesubstantiallyfromyeartoyearin ourprojections,withearningsbeingelevatedintheneartermandfallinglaterasassetsales incursomerealizedcapitallossesandinterestexpenserisestemporarily.Attheendofthe projectionperiod,whentheSOMAportfoliogrowsatitslongruntrend,remittancestothe
2percentlongerrungoal,andlongerterminflationexpectationscontinuetobewellanchored.Moreover,the statementalsoindicatedthatthesethresholdswereconsistentwiththeearlierdatebasedguidancethat suggestedthatexceptionallylowlevelsofthefederalfundsratewerelikelytobewarrantedatleastthroughmid 2015. 8 ThedeferredassetissubsequentlyrealizedasareductionoffutureremittancestotheTreasury(whichare accountedforasinterestonFederalReservenotesexpense).Thus,itisanassetinthesensethatitembodiesa futureeconomicbenefitthatwillberealizedasareductionoffuturecashoutflows.Iftherealizationoftheassetis expectedtooccuroverseveralyears,somevaluationtechnique,suchasnetpresentvalue,wouldbeappliedto measurethevalueoftheasset.ThisaccountingtreatmentisconsistentwithU.S.GAAPandissimilartotheway thatprivatecompaniesreportdeferredlosscarryforwardsasanasset.

Treasuryareabout$45billionperyear.Morebroadly,theintentoftheassetpurchasesisto stimulateeconomicactivityandhelptheFederalReservetofosteritsdualobjectivesof maximumemploymentandstableprices.Chungetal.(2011)providesomeestimatesofthe macroeconomiceffectoftheassetpurchases,whichwouldlikelyresultinhighertaxrevenue, andthiseffectwouldlikelybesubstantiallylargerthananyfluctuationinremittancesbythe FederalReserve. Third,FederalReserveearningsandremittancestotheTreasuryexhibitsensitivitytothe forecastforinterestrates.Toillustratetheseriskstotheprojections,weconsiderascenario wherebothshorttermandlongerterminterestratesare100basispointshigherthaninthe baselineprojection.Relativetothebaselineprojections,underthisassumption,remittancesto theTreasuryceasefor2to3additionalyears,andthedeferredassetspeakatlargeramounts. Inessence,highershortterminterestratesmakeinterestonreservesmorecostly,andhigher longterminterestratesmakesellingMBSmorecostly.Wealsoconsiderascenariowhere ratesare100basispointslowerthaninthebaselineprojection.Thelowerratesdampen realizedlossesandinterestexpense,andasaresult,theFederalReserveremitsearningstothe Treasurythroughouttheprojectionandnodeferredassetisrecorded.Underanyofthe interestratepathsstudiedhere,however,onnet,theFederalReservesnontraditionalpolicy tendstoboostremittancestotheTreasuryovertheprojectionperiodinitsentirety. Thepaperisorganizedasfollows.Section2providesaprimerontheFederalReservesbalance sheetandaccounting,includingtheSOMAportfolioandtheFederalReservesincome statement.Section3outlinestheassumptionsusedasinputstotheprojectionsofthebalance sheet.ThebalancesheetandincomeprojectionsarediscussedinSection4,boththe projectionsforthethreepurchaseoptionsunderthebaselineassumptionforinterestrates, andthesameprojectionswithinterestrateshocksthatillustratetheinterestratesensitivityof theportfolio.Section5concludes.Twoappendixesarealsoincluded.Appendix1provides moredetailontheassumptionsunderlyingtheprojections.Appendix2describesthemethod usedtoderiveprojectionsoffuturevaluationsandincomefromSOMAsecurities.

2 The Federal Reserves balance sheet, income statement, and valuation of the SOMA portfolio
Inthissection,wereviewkeybalancesheetcomponentsinourprojections,aswellasthe incomegeneratedfromthebalancesheet.Wealsoprovidesomehistoricalcontextforthe evolutionoftheseitems.DiscussionofotherassetsandliabilitiescanbefoundinAppendix1.

2.1 The Federal Reserves balance sheet

OurdiscussionoftheFederalReservesbalancesheetwillrefertotheconsolidatedbalance sheetsofthe12individualReserveBankbalancesheets.9Inreality,theaccountingthatwillbe discussedbelowisdoneattheReserveBanklevel;however,forsimplicity,wefocusonthe FederalReserveSystemsaggregatebalancesheet. Likeanybalancesheet,theFederalReservehasassetsononesideofthebalancesheet,which mustequalliabilitiespluscapitalontheotherside.AsshowninTable1,attheendof2006, totalassetsoftheFederalReservewere$875billion,withthesinglelargestassetitembeing theSOMAportfolio,atabout$780billion.Priortothefinancialcrisis,thedomesticSOMA portfoliocomprisedonlyTreasurysecurities,ofwhichroughlyonethirdwereTreasurybillsand twothirdswereTreasurycouponsecurities.Ontheothersideofthebalancesheet,thelargest liabilityitemwaspapercurrency,orFederalReserveNotes(FRNotes),atabout$785billion. Withthelendingthattookplaceduringthefinancialcrisis,foratime,lendingofvarioussorts surpassedthesizeoftheSOMAportfolio.AsofDecember26,2012,however,theSOMA portfoliowasagainthelargestassetitem,andithadgrownto$2.6trillionbecauseoftheasset purchaseprograms.Ontheliabilitysideofthebalancesheet,FRNotes,atabout$1.1trillion, werenolongerthelargestliabilityitem.Instead,astheFOMCincreaseditsassetpurchases, reservebalancesincreasedcorrespondinglytoalevelabout$1.5trillion.

TheBoardofGovernorsdoesnotholdassetsandliabilitiesinthesamewaythattheReserveBanksdo.Section 10oftheFederalReserveActauthorizestheBoardtolevysemiannuallyupontheReserveBanks,inproportionto theircapitalstockandsurplus,anassessmentsufficienttopayitsestimatedexpensesforthehalfoftheyear succeedingthelevyingofsuchassessment,togetherwithanydeficitcarriedforwardfromtheprecedinghalfyear.

Table1:FederalReserve'sBalanceSheet,end2006andpresent
Balancesheetend2006 billionsof$ Assets Liabilities SOMA 779 DepositsofDIs 13 Otherassets 95 FRnotes 783 Otherliabilities 49 memo:Capital
Source:H.4.1StatisticalRelease

BalancesheetDecember26,2012 billionsof$ Assets Liabilities SOMA 2,661 DepositsofDIs 1,533 Otherassets 248 FRnotes 1,125 Otherliabilities 198 memo:Capital 55

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ThenextfewsubsectionsreviewthekeycomponentsoftheFederalReservesbalancesheet andhowtheyhavechanged.10 2.1.1 The SOMA portfolio: Composition, size, and maturity structure Overmostofthepostwarperiod,theSOMAportfoliowasthelargestassetitemontheFederal Reservesbalancesheet.11Duringthattime,theSOMAportfolioessentiallyheldTreasury securities;however,theportfoliohasheldothertypesofsecuritiesinitsportfoliooverits history.12Forexample,from1971to1981,theFederalReservepurchasedlimitedquantitiesof agencysecurities;thelastofthesesecuritiesmaturedintheearly2000s,andnonewas purchaseduntil2008.13 Historically,thesizeoftheSOMAportfolioandthebalancesheetmoregenerallyreflected growthinFRNotesandReserveBankcapital.Whencurrencyisputintocirculation,itis shippedtoadepositoryinstitutionandthatinstitutionsaccountattheFederalReserveis debitedbyanequivalentamount.Becausecurrencyoutstandingtendstotrendupward,over timecurrencygrowthwouldtendtoreducetheamountofreservebalancesinthebanking system.TheFederalReservewouldpurchasesecuritiesinopenmarketoperationstooffsetthis drainofreserves.Onnet,therefore,thegrowthrateofcurrencytendedtodrivethesizeofthe
Foradescriptionofadditionalcomponentsofthebalancesheet,seetheinteractiveguidestotheH.4.1tablesat http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm,ortheFinancialAccountingManualat http://www.federalreserve.gov/monetarypolicy/files/bstfinaccountingmanual.pdf. 11 ForadescriptionoftheFederalReservesbalancesheetpriortoWorldWarII,seeBankingandMonetary Statistics,19141941(1943). 12 RefertoEdwards(1997). 13 RefertoMeltzer(2010).
10

balancesheet.Similarly,whenadepositoryinstitutionisrequiredtosubscribetoalarger amountofFederalReservecapitalortheFederalReserveaddstoitssurplusaccount,theresult wouldbeallelseequalareductioninreservebalances.14Asaresult,theSOMAportfolio mustincreasetooffsettheseincreasesaswell,creatingalargerbalancesheetoverall. ThishistoricalpatternisillustratedinFigure4.Ascanbeseen,through2007,boththeSOMA portfolioandcurrencyandcapitaltrendedupwardtogether.Whentheassetprogramsbegan inlate2008andearly2009,andcontinuingthroughthesecondroundofpurchasesin2010and 2011,theSOMAportfolioincreasedmarkedlyandataratethatfaroutpacedthegrowthof currencyandcapital.Withtheinitiationofthematurityextensionprogramin2011,thesizeof theportfolioremainedroughlyconstant;however,asdepictedinFigure5,theweighted averagematurityofTreasurysecuritiesintheSOMAportfolioincreasedmarkedly.Froma longerperspective,overtime,theSOMAportfoliohashadarangeofmaturitiesofTreasury securitiesinitsholdings.15Priortothefinancialcrisis,theDesktendedtopurchasesecurities acrosstheentireyieldcurvetoavoiddistortingtheyieldcurve.Butafterthestartofthe financialcrisis,thematurityofTreasurycouponsecuritiesintheSOMAportfoliolengthened notably,reflectingtherunoffinbillstosterilizethecreditandliquidityprogramsin2008,and thepurchaseoflongerdatedsecuritiesmorerecently. 2.1.2 Deposits of depository institutions DepositsofdepositoryinstitutionsincludealldepositoryinstitutionsbalancesattheFederal Reservethatareusedtosatisfyreserverequirementsandbalancesheldinexcessofbalance requirements.Depositsofdepositoryinstitutionsgrewdramaticallythroughthecrisis,andare currentlyquiteelevatedbyhistoricalstandards.Whenwerefertoreservebalances,weare usingthedepositsofdepositoryinstitutionsconcept.Thesedepositsrepresentfundsthat depositoryinstitutionsowntheyarealiabilityoftheReserveBank,butanassetofthe depositoryinstitution.Thesefundsarealsousedforpaymentsystemsettlementforexample, apaymentfromonebanktoanother(orfromonebankscustomertothecustomerofa
Aswillbemorefullyexplainedlaterinthepaper,eachmemberbankofaReserveBankisrequiredtosubscribe tothecapitalofitsdistrictReserveBankinanamountequalto6percentofitsowncapitalstock. 15 IntheweeklyH.4.1statisticalrelease,inadditiontotheFederalReservesbalancesheet,thematurity distributionofassetholdingsisalsopublished.
14

differentbank)typicallyresultsinadebittothepayingbanksaccountandacredittothe receivingbanksaccount.Lendingofreservebalancesandpaymentactivityresultonlyina movementofreservebalancesfromonedepositoryinstitutionsaccountattheFederalReserve toanotherinstitutionsaccount;theaggregatequantityisunchanged. 2.1.3 Federal Reserve Notes FederalReservenotes,orcurrency,arealiabilityoftheFederalReserve.Asapracticalmatter, thequantityofcurrencyoutstandingisnotdeterminedbytheFederalReserve.Instead,when adepositoryinstitutionwantstoholdcurrencyinitsvaultorautomatictellermachinesinorder tomeetcustomerneeds,itrequestsashipmentfromitsFederalReserveBank.Whenthat shipmentismade,thedepositoryinstitutionsreserveaccountattheReserveBankisdebited bytheamountofthecurrencyshipment.OneimportantsourceofdemandforU.S.currencyis fromoverseas.Althoughitisimpossibletoknowwithcertaintywhatportionofcurrency outstandingisoutsideoftheUnitedStates,estimatessuggestthatthefractionisonehalfor more.16Priortothefinancialcrisis,currencywasthelargestliabilityitemontheFederal Reservesbalancesheet. 2.1.4 Capital paidin, surplus, and interest on Federal Reserve notes due to U.S. Treasury ThecapitaloftheReserveBanksisdifferentthanthecapitalofotherinstitutions.17Itdoesnot representcontrollingownershipasitwouldforaprivatesectorfirm.Ownershipofthestockis requiredbylaw,theReserveBanksarenotoperatedforprofit,andthestockmaynotbesold, traded,orpledgedassecurityforaloan.AsstipulatedinSection5oftheFederalReserveAct, eachmemberbankofaReserveBankisrequiredtosubscribetothecapitalofitsdistrict ReserveBankinanamountequalto6percentofitsowncapitalstock.Ofthisamount,half mustbepaidtotheFederalReserveBanks(referredtoascapitalpaidin)andhalfremains subjecttocallbytheBoardofGovernors.Thiscapitalpaidinisarequiredassessmentonthe memberbanksanditssizechangesdirectlywiththecapitalofthememberbanks.Also

RefertoJudsonandPorter(1996). SeetheFinancialAccountingManualforFederalReserveBanks,whichreportstheaccountingstandardsthat shouldbefollowedbytheFederalReserveBanksat www.federalreserve.gov/monetarypolicy/files/bstfinaccountingmanual.pdf, pageI68.

17

16

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stipulatedbylawisthatdividendsarepaidatarateof6percentperyear.Overthepast decade,reflectingincreasesincapitalatmemberbanks,ReserveBankcapitalhasgrownatan averagerateofalmost15percentperyear.Inaddition,ReserveBankshavesurpluscapital, whichreflectswithheldearnings,andFederalReserveBankaccountingpoliciesstipulatethat theReserveBankswithholdearningssufficienttoequatesurpluscapitaltocapitalpaidin.Asa result,ascapitalofmemberbanksgrowsthroughtime,capitalpaidingrowsinproportion. Becausesurplusissetequaltocapitalpaidin,itlikewisegrowsatthesamerateasmember bankcapital. Oneliabilityitemisdistinctfromtheothers.Asnotedabove,underitsremittancepolicythe FederalReserveremitsallnetincometotheU.S.Treasury,afterexpensesanddividendsand allowingforsurplustobeequatedtocapitalpaidin.Asthoseearningsaccrue,theyare recordedontheFederalReservesbalancesheetasInterestonFederalReservenotesdueto U.S.Treasury.Intheeventthatearningsonlyequaltheamountnecessarytocoveroperating costs,paydividends,andequatesurplustocapitalpaidin,thisliabilityitemwouldfalltozero becausetherearenoearningstoremitandthepaymenttotheTreasurywouldbesuspended. Ifearningsareinsufficienttocoverthesecoststhatis,thereisanoperatinglossinsome periodthennoremittanceismadeuntilearnings,throughtime,havebeensufficienttocover thatloss.Thevalueoftheearningsthatneedtoberetainedtocoverthislossiscalleda deferredassetandisbookedasanegativeliabilityontheFederalReservesbalancesheet underthelineitemInterestonFederalReservenotesduetotheU.S.Treasury.Asdiscussed aboveinfootnote8,itisanassetinthesensethatitreflectsareductionoffutureliabilitiesto theU.S.Treasury. OneconsequenceofthecurrentimplementationofFederalReserveBankaccountingpolicyis thattherecordingofadeferredassetimpliesthatReserveBankcapitaldoesnotdeclineinthe eventofanoperatingloss.Fromtimetotime,individualReserveBankshavereporteda deferredasset;however,thesedeferredassetsweregenerallyshortlived.18Ithasneverbeen

Forexample,asshownontheH.4.1StatisticReleasefromNovember3,2011,theFederalReserveBankofNew YorkrecordedalargeenoughdeferredassetsothattheFederalReserveSystemalsodid.

18

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thecasethattheFederalReserveSystemasawholehassuspendedremittancestothe Treasuryforameaningfulperiodoftimebecauseofoperatinglosses.

2.2 The Federal Reserves income statement

AstheFederalReservesbalancesheethasexpandedinrecentyears,theincomederivedfrom thebalancesheethasalsogrown,thoughthekeylineitemsfromthebalancesheetthat generatedthisincomearethesame.AsshowninTable2,netincomeinboth2006and2011 wasdrivenbyinterestincomefromtheSOMAportfolio.Despitethedifferenceinmagnitude, inbothyears,SOMAinterestincomewasmorethan95percentoftotalincome.Thatsaid, SOMAinterestincomegrewsubstantiallyoverthisperiodastheSOMAportfolioexpanded. Interestexpense,ontheotherhand,wasminimalinbothyears.Inparticular,FRnotesarea largeliabilitywithoutanassociatedinterestexpense.And,althoughtheFederalReservehas paidinterestonreservebalancessinceOctober2008,thisliabilityitemhasincurredlittle interestexpensebecausetheinterestonexcessreserves(IOER)ratehasbeenat25basispoints sinceDecember2008.Inbothyears,otheritemsintheincomestatementweresimilar.In total,remittancestotheTreasurywerepositiveinbothyears,butmuchlargerin2011because oftheexpandedSOMAportfolio. Table2:Incomeandexpenses,2006and2011
Incomeandexpenses,2006 billionsof$ Income Interestincome Otherincome Expense Interestexpense Otherexpense Income Interestincome Otherincome Incomeandexpenses,2011 billionsof$ Expense Interestexpense Otherexpense

36.8 1.6

1.3 3.7

84.5 0.7

3.8 4.5

memo:Additions/deductions, dividends,andtransfers

4.3

memo:Additions/deductions, dividends,andtransfers

1.5

Source:FederalReserveAnnualReport

ThenextfewsubsectionsreviewthekeylineitemsoftheFederalReservesincomestatement inmoredetail.

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2.2.1 SOMA interest income Asnotedabove,incomeonthesecuritiesheldintheSOMAportfolioconstitutesthevast majorityofinterestincome.SOMAinterestincomeprimarilyreflectsthesizeoftheportfolio andtheweightedaveragecoupon(WAC)oftheportfolio,lessanyamortizednetpremiums paidonsecurities.19Asnotedabove,priortothefinancialcrisis,thesizeoftheportfolio increasedsteadilyatamoderaterate.Withtheadoptionoftheassetprograms,thesecurities portfolioexpandedrapidlyandnowstandsatalevelnoticeablyaboveitslongerruntrend.The WAC,asshowninFigure6,fluctuatedovertime,risingandfallingwiththemarketratesand theSOMAportfoliosholdings.ThispatternprimarilyreflectsthefactthattheFederalReserve reinvestsmaturingTreasurysecuritiesatauction,andthecouponatauctiontendstobeinline withmarketrates.Althoughtheassetpurchaseprogramsresultedinasignificantaccumulation oflongertermdebtinrecentyears,muchofitwasissuedinalowinterestrateenvironment and,therefore,theWACoftheportfoliodecreasedsomewhat. PuttingthesizeoftheportfolioandtheWACoftheportfoliotogether,asshowninFigure7, interestincomeclimbedatamoderatepaceintheyearspriortothefinancialcrisis,primarilyas aresultofthesteadyincreaseinthesizeofSOMA,whichroseinlinewiththegrowthofFR notesandcapital.Beginningin2009,interestincomefromtheportfoliorosenoticeablyas largescaleassetpurchasesincreasedthesizeoftheportfolio. 2.2.2 Interest expense Withtheintroductionofinterestonreservesinthefallof2008andtheconcurrentriseinthe levelofreservebalances,interestexpenserose.Asmentionedabove,theIOERratehasbeen 25basispointssinceDecember2008,andasaresult,evenwithasubstantialvolumeofreserve balances,interestexpensefromreservebalanceshasbeenlowcomparedtointerestincome andwasroughly$3.8billionin2011. Inadditiontointerestexpensefromreservebalances,thereisalsointerestexpensefrom reverserepurchaseagreements(RRPs),mostlygeneratedbytheforeignrepurchaseagreement
SOMAinterestincomeisdefinedastherateofreturnontheportfolio(theproductofthesizeoftheportfolio timestheWAC)minusamortizednetpremiums.Netpremiums,thoughimportantinderivingtheprecisevalueof interestincome,willnotbeaprimarydriverofthecontouroftheprojectionsofinterestincome.
19

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(RP)pool.20,21InterestratespaidontheforeignRPpoolaregenerallyinlinewithmarketrates, andwhenreservebalancesarerelativelylow,interestexpenseontheforeignRPpoolcan representalargeshareoftotalinterestexpense. Reverserepurchaseagreementswithprimarydealersandotherinstitutionsandtheterm depositfacility(TDF)alsohaveassociatedinterestexpense.Inadditiontotheprimarydealers, theFederalReserveselectedmoneymarketmutualfunds,FederalHomeLoanMortgage Corporation(FreddieMac),FederalNationalMortgageAssociation(FannieMae),andsome banksaspotentialcounterpartiesforRRPs.BycontrasttotheRRPs,onlybanksarethe counterpartiesinTDFtransactions.AlthoughtheFederalReservehasdevelopedthecapability ofconductinglargescaleoperationsineithertheRRPsorTDF,neitherhasbeenusedina materialsizetodate,andasaresult,interestexpenseassociatedwiththesefacilitieshasbeen minimal. 2.2.3 Capital gain (loss) UnderFederalReserveaccountingrules,aFederalReserveBankrealizesgainsorlossesona securityonlywhenthesecurityissold.Atsale,wecalculatetheFederalReservesgainorloss asthemarketvalueminustheparvalueandunamortizednetpremiumsonthesecurity. Historically,theFederalReservedidnotgenerallysellsecurities,becausetheseculargrowthin currencyresultedinaneedforalongtermincreaseinsecuritiesholdings.In2008,however, theDeskdidsellsomesecuritiestooffsettheexpansionofthebalancesheetthatresultedfrom theintroductionoftheliquidityfacilitiesattheearlystagesofthefinancialcrisis.Inthatyear, theFederalReserverealizedacapitalgainofroughly$3billionbecausemarketrateshadfallen, pushingupthemarketpriceofthesecuritiessold.Withthematurityextensionprogram,the FederalReservehasalsosoldsecurities.In2011,thesesalesrealizeda$2.3billioncapitalgain.

BeforeDecember13,2002,repotransactionswereconductedasmatchedsalespurchasetransactions,where theFederalReservesoldasecuritywithanagreementtopurchaseitagainatalaterdate.However,because matchedsalepurchasetransactionswereaccountedforasanoutrightsaleratherthanasafinancingtransaction thewayreverserepurchaseagreementsare,thetransactionsdidnotresultininterestexpense. 21 EverybusinessdaytheFederalReserveconductsovernightreversereposwithforeigncentralbanksthathold dollarsintheiraccountsattheFederalReserveBankofNewYork.Thesetransactionsareoneoftheservicesthat centralbanksprovideoneanothertofacilitatetheirinternationaloperations.

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2.2.4 Payment of dividends, transfers to surplus, and interest on Federal Reserve notes due to the U.S. Treasury Asnotedabove,memberbanksarerequiredtosubscribetothecapitalstockoftheReserve Banks,andtheActstipulatesthattheFederalReservepaya6percentdividendonthiscapital. UnderpolicyprescribedbytheBoardofGovernors,excessearningsareretainedassurplus capitalinanamountequaltocapitalpaidin.BeforeremittancestotheTreasuryaremade dividendsarepaidandearningsareretainedtoequatesurplustocapitalpaidin.Dividendsare paidevenifremittancestotheTreasurywouldbezero.Asdiscussedearlier,intheeventthat earningsfallshortoftheamountnecessarytocoveroperatingcosts,paydividends,andequate surplustocapitalpaidin,theFederalReservebooksaliabilityofinterestonFederalReserve notesduetoU.S.Treasury.ThislineitemisrecordedinlieuofreducingtheReserveBanks surplus,andrepresentstheamountofearningstheFederalReserveneedstoaccumulate beforeitresumesremittingresidualearningstoU.S.Treasury. 2.2.5 Remittances to the Treasury TheFederalReserveremitsanyearningsinexcessofoperatingexpensesanddividendstothe Treasury.22TheuseofthesefundsisstipulatedintheFederalReserveAct,whichstates: ThenetearningsderivedbytheUnitedStatesfromFederalReservebanksshall,inthe discretionoftheSecretary,beusedtosupplementthegoldreserveheldagainst outstandingUnitedStatesnotes,orshallbeappliedtothereductionoftheoutstanding bondedindebtednessoftheUnitedStatesunderregulationstobeprescribedbythe SecretaryoftheTreasury.23 Overtime,asshownearlierinFigure3,remittancesremainedinarelativelysmallrange, averagingabout$25billionintheyearsimmediatelyprecedingthefinancialcrisis.Duringthe crisis,asFederalReserveincomeincreasednotably,sodidremittancestotheTreasury.Still, remittancesremainedarelativelysmallshareofgovernmentreceiptsdwarfedbyindividual incomeandcorporateincometaxes,asshowninFigure8,andaboutinlinewithcustoms deposits(notshown). 22 Occasionally,statutorytransfersoccur,whichmandatethattheFederalReservetransferaportionofitssurplus
totheTreasury.Thelasttimethisoccurredwasin2000,whenapproximately$3.8billionheldinthesurplus accountwastransferredtotheTreasury. 23 FederalReserveAct,Section7,UseofEarningsTransferredtotheTreasury,12USC290,subsection(b).

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2.3 Valuation of the SOMA portfolio

ThereareanumberofdifferentwaystorecordthevalueoftheSOMAportfolio.ReserveBank accountingrecordstheSOMAportfolioatparvalue.Theparvalueoftheportfolio,reportedin line1ofTable3,givesthefacevalueofthesecuritiesintheportfolio.Thisisthevalueofthe portfolioreportedintheweeklyH.4.1statisticalrelease.Theamortizedcostoftheportfolio, alsocalledthebookvalueoftheportfolioandshowninline3,istheparvalueoftheportfolio plusanyunamortizednetpremiumsassociatedwiththesecurities.Athirdvaluationofthe portfolioisthemarketvalue,line4.TheFederalReserveBanksCombinedQuarterlyFinancial ReportsandtheAnnualReportalsoreportthefairvalue(essentiallythemarketvalue)ofthe portfolio.24Asinterestrateschange,themarketvalueofthesecuritiesintheportfoliochanges. Thedifferencebetweenthemarketvalueandthebookvalueistheunrealizednetgain(orloss) positionoftheportfolio,line5.AsoftheendofSeptember2012,theportfoliohadan unrealizedgainof$249billion,reflectingagainoneachofthethreetypesofsecurities holdings.25September2012isthelastpublishedinformationonthepositionoftheportfolioas ofthewritingofthispaper;however,asimilarcalculationispossibleatanytime.Inparticular, theFederalReserveBankofNewYorkpublishestheCUSIPofeverysecurityheldintheSOMA portfolio.CombiningtheseCUSIPswithmarketpricesforthesecuritiesallowsforthe calculationonanydayofthemarketvalueoftheFederalReservesportfolio.Arough calculationoftheunrealizedgainorlosspositionoftheportfolioisalsopossible.26

ThequarterendmarketvalueoftheSOMAportfolioispublishedintheFederalReserveBanksCombined QuarterlyFinancialReports(Unaudited),availableat http://www.federalreserve.gov/monetarypolicy/bst_fedfinancials.htm#quarterly.Alternatively,theFederal ReserveBankofNewYorkpublishestheCUSIPsofallofthesecuritiesintheFederalReservesportfolio.Matching theseCUSIPswithcurrentmarketpricesallowsforanestimateofthecurrentmarketvalueoftheportfolio. 25 Importantly,eveniftheSOMAportfoliowasinanunrealizednetlossposition,theabilityoftheFederalReserve toimplementmonetarypolicywouldnotbehampered. 26 Inadditiontothemarketpriceoftheportfolio,theamortizedcostoftheportfolioisrequiredtocalculatethe unrealizedgainorlossposition.Inrealtime,amortizedcostcanbeeasilyapproximatedbytheparvalueofthe portfolio,whichispublishedweekly,andthenetunamortizedpremiums,whichareincludedintheweekly publicationofthebalancesheetandareexplicitlypublishedquarterly.

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Table3:ValueoftheSOMAportfolioasofSeptember30,2012 ($billions) Treasuries AgencyDebt AgencyMBS TotalSOMA 1.Parvalue* 1,648 85 848 2,581 2.Netpremiums 131 1 3 135 3.Amortizedcost 1,779 86 851 2,716 4.Marketvalue 1,968 92 904 2,964 5.UnrealizedGain/Loss 189 6 53 248
*ParvalueasofSeptember28,2012fromtheH.4.1StatisticalRelease. Source:FederalReserveBanksCombinedQuarterlyFinancialReport,September2012.

3 Projections assumptions
InordertoconstructprojectionsoftheFederalReservesbalancesheet,assumptionsabout manyofthedetailsofthebalancesheetanditsevolutionmustbemade.Thefollowing subsectionsreviewassumptionsmadeaboutkeylineitemsofthebalancesheet.Adetailed descriptionoftheseandadditionallineitemsisfoundinAppendix1.

3.1 Interest rate assumptions

Toevaluatethecurrentandfuturevalueofsecurities,andthereforetheSOMAportfolio, assumptionsmustbemadeaboutthepathofinterestratesovertheprojectionperiod.Forthis analysis,werelyoninterestrateprojectionsfromtheDecember2012BlueChipforecastfor thefederalfundsrateandthetenyearTreasuryrate.Weusethemeanquarterlyratesfrom 2012:Q4through2014:Q1,theannualratesfrom2014through2018,andthe5yearaverage ratefrom20192023.27Theassumedpathforthefederalfundsrateandtheyieldontheten yearTreasurynoteareshowninFigure9.Thefederalfundsrateremainsinthe0topercent rangeuntilthefirstquarterof2015.ThisBlueChipforecastrisesslightlyearlierthaninthe October2012FOMCstatementandsubsequentcommunicationsbyFederalReserveofficials;in otherwords,theBlueChipforecast,andthereforetheforecastusedinthispaper,isnotthe FOMCforecast.Afterthatpoint,therateisprojectedtoriseandstandat3.8percentin2025. TheyieldonthetenyearTreasurynotealsorises,fromitscurrentlowlevelof1.7percentto 4.9percentattheendoftheprojectionperiod.Theseforecastsdonotrepresenttheviewsof
27

Weusethe5yearaverageinterestrateasourvaluein2024and2025.

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theFederalReserveoritsstaff.Theresultsofthesimulationspresentedinthispaperwouldbe differentunderalternativeassumedpathsformarketinterestrates. Toperformtheassetvaluationsthatwillberequired,however,anentireyieldcurveisneeded. Asaresult,wecreateayieldcurveateachpointintimeovertheprojectionperiodusing historicalrelationshipsbetweenthefederalfundsrate,thetenyearTreasuryrateandselected intermediatetenors.Assetvaluationisneeded,forexample,toprojecttheeffectonreserves ofsellingMBSasenvisionedintheFOMCsexitprincipleswhenasecurityissold,reserves declinebythesale(market)priceofthesecurity,notbytheparvalue.Thehigherthemarket valueofthesecurity,themorereserveswouldbedrainedthroughthesale.Thelowerthe marketvalue,thereversewouldbetrue.MoredetailsareprovidedinAppendix2.

3.2 Nearterm balance sheet assumptions

Thissubsectionreviewsourprojectionmethodologyforselectedassetandliabilityitemsthat areofparticularinterest.Allelementsofthebalancesheetareprojected,butweleavethose oflessinteresttoAppendix1. 3.2.1 SOMA portfolio TheevolutionoftheSOMAportfolioisintendedtobeconsistentwiththeFOMCstatementon December12,2012.Inparticular,weassume: (1) Thematurityextensionprogram(MEP),whichstartedinSeptember2011,iscompleted attheendof2012,asis$40billioninMBSpurchasespermonth; (2) ReinvestmentofprincipalpaymentsfromagencysecuritiesintoagencyMBScontinues inthenearterm,wherebynearterm,wemeantheperiodoftimebetweennowand thebeginningofanexitstrategyfromthecurrentaccommodativemonetarypolicy stance.28 (3) Additionalpurchasesofsecuritiesareconductedin2013atapaceof$45billionper monthinlongertermTreasurysecuritiesand$40billionpermonthinagencyMBS.As thecurrentpurchaseprogramisopenendedandconditionalonmacroeconomic
TheexitstrategyandothertimingissueswillbediscussedinfurtherdetailinSection3.3.

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outcomes,weusezero,$500billion,and$1trillionintotalpurchasesin2013to illustratethepossiblebalancesheetcontoursandincomeimplicationsoftheopen endedprogram.Ofnote,the$1trillionprogramisinlinewiththemedianresponsein theOctober2012PrimaryDealersurveyconductedbytheDesk.Thepurchasesof Treasurysecuritiesareassumedtobeinthematuritydistributionannouncedbythe DeskinconjunctionwiththeFOMCstatementonDecember12,whichhasroughlythe samenetdurationasinasinthematurityextensionprogram. GiventheinitialcompositionoftheSOMAportfolioonOctober31,2012,theportfolioevolves overtime.WeadjustthematuritystructureofholdingsofTreasurysecuritiesandagency securitiesthroughtimetoreflect(1)through(3)andthepassageoftime.Moreover,the forecastforfuturepurchasesimposestheassumedconstraintthatSOMAholdingsthatanyone CUSIPremainbelow70percentofthetotalamountoutstandinginthatCUSIP,asannouncedby theFederalReserveBankofNewYork. SimilartotheuseofBlueChipprojectionsforinterestrates,weturntopublicprojectionsfor theTreasurysissuanceofmarketabledebt.Weuseprojectionsofboththeamountandthe maturityofTreasuryissuanceinordertoprojectsecuritiesavailableforpurchasebytheFederal Reserve.WeuseTreasuryissuanceasofOctober2012,andfromthatpointforward,coupled withtheCongressionalBudgetOfficesJanuary2012projectionsfortotalTreasurydebt outstanding,wegeneratethelevelandmaturitystructureofmarketabledebtoutstanding.29In addition,weassumethattheaveragematurityofTreasurydebtoutstandingextendsfromits currentlevelof62monthsto70monthsby2015,roughlyconsistentwiththeTreasurysstated intentionsasofNovember2011andAugust2012.30Therefore,futureTreasurypurchasesare associatedwithcouponsthatevolveovertimereflectingprojectionsininterestrates,Treasury issuance,andthe70percentownershiprule.
AsofJanuary2013,thebudgetmeasuresagreedtosofaraspartoftheAmericanTaxpayerReliefActof2012 wouldlikelynotmateriallyaffectourprojections.Othermeasuresthatcouldbeadoptedlaterinthespringof 2013aredifficulttoforecastandbeyondthescopeofthispaper. 30 Refertohttp://www.treasury.gov/presscenter/pressreleases/Pages/tg1665.aspxand http://www.treasury.gov/presscenter/pressreleases/Pages/tg1349.aspx.
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AcoupleofparticularsregardingFederalReserveaccountingandvaluationofsecuritiesshould benoted.Specifically,FederalReserveaccountingrecordsthesecuritiesholdingsatfacevalue andrecordsanyunamortizedpremiumordiscountintheotherassetscategory. Consequently,wemustprojectboththefacevalueoftheportfolioandtheassociated premiums.Toprojectpremiumsonfuturesecuritiespurchasesweneedtocalculatethe marketvalueofsecuritiesinthefuture.Wetakethemarketvalueforsecuritiesasthepresent discountedcashflowofthesesecuritiesusingthecouponratetogeneratecashflowsandthe yieldcurvesdescribedinSection3.1andAppendix2todiscountthesecashflows.The premiumisthedifferencebetweenthefacevalueandthemarketvalueofthesecurity. Treasurysecuritiesthatarerolledoveratauctionareassumedtobepurchasedatpar,and thereforehavenopremium. ForMBSreinvestment,weneedtoprojectthecouponofthesecuritiesthatwillbepurchased. ThemodelusedforthatisdescribedinAppendix2.Becausereinvestmentsareassumedto continueonlyinthenearterm,weassumethatpurchasesofMBStakeplaceataprice4 percentabovefacevalue,consistentwithrecentMBSreinvestmentactivity. 3.2.2 Liabilities and capital Inourmodeling,twoitemsareimportantexogenousdriversofthebalancesheetcontourFR notesandcapitalpaidin.Forsimplicity,weassumethatFRnotesgrowinlinewiththeBlue ChipforecastfornominalGDP.Capitalpaidinisassumedtogrowatitsdecadeaverageof15 percentperyear,andsurplusisequatedtocapitalpaidin.Thisgrowthrateplaysaroleinthe longruntrendgrowthrateoftheSOMAportfolio. Reservebalances,animportantliabilityitemfortheFederalReserve,areendogenoustoour projectionsandingeneralcalculatedastheresidualofassetslessotherliabilitieslesscapitalin thebalancesheetprojections.However,weassumeaminimumlevelof$25billionissetfor reservebalances.Thatlevelisroughlyconsistentwiththelevelofreservebalancesobserved priortothefinancialcrisis.BothFRNotesandcapitalaretrendinghigherintheseprojections. Tomaintainreservebalancesat$25billion,weassumethattheDeskbeginstopurchase Treasurybills.Purchasesofbillscontinueuntilthesesecuritiescompriseonethirdofthe 20

FederalReservestotalTreasurysecurityholdingsasnotedabove,abouttheaverage proportionofTreasuryholdingspriortothecrisis.Oncethisproportionofbillsisreached,we assumethattheDeskbuyscouponsecuritiesinadditiontobillstomaintainanapproximate compositionoftheportfolioofonethirdbillsandtwothirdscouponsecurities.

3.3 Exit strategy assumptions for the balance sheet

Fortheneartermprojections,wenotethattheFOMCcompletedtheMEPand$40billionin MBSpurchasesinDecember2012,andassumetheFOMCbeginsoneofthethreepurchase scenarios($0,$500billion,or$1trillion)in2013.Furtheroutintheprojectionperiod,webase ourprojectionsonthegeneralprinciplesfortheexitstrategythattheFOMCoutlinedinthe minutesoftheJune2011FOMCmeeting.31TheCommitteestatedthatitintendedtotakethe followingstepsinthefollowingorder: (1) Ceasereinvestingsomeorallpaymentsofprincipalonthesecuritiesholdingsinthe SOMA; (2) Modifyforwardguidanceonthepathofthefederalfundsrateandinitiatetemporary reservedrainingoperationsaimedatsupportingtheimplementationofanincreasein thefederalfundsratewhenappropriate; (3) Raisethetargetfederalfundsrate; (4) Sellagencysecuritiesoveraperiodofthreetofiveyears;and (5) Oncesalesbegin,normalizethesizeofthebalancesheetovertwotothreeyears. Theseprinciplesrepresentaroughguidetotheexitstrategy.Inparticular,atthattime,the Committeestatedthatispreparedtomakeadjustmentstoitsexitstrategyifnecessaryinlight ofeconomicandfinancialdevelopments. Tocompletetheprojections,however,weneedtomakeadditionalassumptions.Wetie changesintheSOMAportfoliotothedatethefederalfundsrisesfromitseffectivelower bound,which,basedontheBlueChipforecasts,weassumeisMarch2015.Weassumethat thereinvestmentofsecuritiesendssixmonthsbeforethisdate.Wedonotexplicitlymodelthe
MinutesoftheFederalOpenMarketCommittee,June2122,2011,availableat http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20110622.pdf.
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useofreservedrainingtools.32Weassumethatsalesofagencysecuritiesbeginsixmonths afterthefederalfundsratebeginstoriseandthatthebalancesheethasreturnedtonormal sizeoveraboutthreeyears.Ininterpretingnormalsizewerelyonthe$25billionminimum levelforreservebalancesasnormal.WesummarizetheassumedexitstrategyinTable4.33 Table4:Keyassumptionsusedinbalancesheetprojections

$02013 Purchases $667 billion 15 months Oct11 Dec12 $500bn2013 Purchases $667 billion 15 months Oct11 Dec12 $1tr2013 Purchases

Assumption MEPTreasuryPurchases Amount Length Firstmonth Lastmonth MEPTreasurySalesorRedemptions Amount Length Firstmonth Lastmonth CurrentPortfolioStrategy Agencyreinvestments 2013TreasuryandMBSPurchases Amount Length Firstmonth Lastmonth MBSpurchasepace Treasurypurchasepace ExitStrategy FedFundsliftoff Redemptionsstart Agencysales Salesstart Salesend

$667 billion 15 months Oct11 Dec12

AgencyMBS

N/A N/A N/A N/A N/A N/A

$667billion 15months Oct11 Dec12 $667 billion $667billion 15 months 15months Oct11 Oct11 Dec12 Dec12 AgencyMBS AgencyMBS $500billion $1trillion 6 months 12months Jan13 Jan13 Jun13 Dec13 $40bn/month $40bn/month $45bn/month $45bn/month Mar15 Sept14 Sept15 Aug19

Mar15 Sept14 Sept15 Aug19

Mar15 Sept14 Sept15 Aug19

Iftermdepositsorreverserepurchaseagreementswereusedtodrainreservespriortoraisingthefederalfunds rate,thecompositionofliabilitieswouldchange:Reservebalanceswouldfallastermdepositsandreverse repurchaseagreementsrose.Presumably,thesedrainingtoolswouldbewounddownasthebalancesheet returnedtoitssteadystategrowthpath,sothattheprojectedpathforSOMAholdingspresentedhereremains valid. 33 Iftheexpecteddateofthefederalfundsliftoffislaterthanassumedhere,thestartdatesfortheexitstrategy principleswillsimilarlybedelayedbutthecontoursoftheprojectionspresentedherewillberoughlyunchanged.

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Otherlineitemsonthebalancesheetcontinueontheirprojectedpathasnotedabove.

3.4 Income projections assumptions

BasedonprojectionsofthesizeandcompositionoftheFederalReservesbalancesheet,a projectedpathforinterestrates,andsomeotherassumptions,wecancalculateanimplied projectionfortheFederalReservesearnings,expenses,andremittancestotheTreasury. Again,thedetailsofReserveBankaccountingmatter,butwewilldiscusstheprimary determinants,whichareinterestincome,interestexpense,capitalgainsorlosses,and remittancestotheTreasury.Thissectiondescribesthekeyassumptionsbehindtheincome projection,whileAppendix1providesadditionaldetails. 3.4.1 SOMA interest income Notsurprisingly,sincetheSOMAportfolioisthelargestassetitem,itgeneratesthebulkof FederalReserveBankearnings.InterestincomereflectsthecouponpaymentsfromtheSOMA portfoliosholdingsofsecuritiesminustheamortizationofpremiumsonthoseholdings.To createtheprojectionsofinterestincome,therefore,wemusttracktheevolutionofthe portfoliofrompurchases,sales,andmaturingsecurities.Asthecompositionoftheportfolio evolves,thecouponontheportfolioevolves.Theamortizationofpremiumsreducesinterest income,sotheassumptionsaboutthepremiumsonthesecuritiespurchasedaffectthe calculationofinterestincome. FocusingonincomefromTreasurysecurities,forsimplicity,wedividetheSOMAportfolio holdingsintobucketsbymaturityinsteadofanalyzingeachCUSIP.Specifically,weaggregate CUSIPSbymonthofmaturity,treatingallsecuritiesmaturingwithinagivenmonthasasingle security.Basedonthesebuckets,wecalculatetheWACoftheportfolioandmultiplythatby theholdings.Next,wesubtractoffamortizednetpremiums. TheprojectionoftheSOMAportfolioandtheassociatedpremiumswerediscussedinSection 3.2.1.AsofOctober31,2012,theWACoftheTreasuryportfolioisknown.Fortheprojection, weseparatepurchasesofsecuritiesfromreinvestment.Purchasesoccurinthesecondary marketatprojectedmarketprices.Overtime,theaveragecoupononTreasurysecuritiesinthe secondarymarketevolvesasexistingTreasuryissuanceagesandprojectednewissuanceis 23

introducedintothemarket.ThestartingpointofthecouponratesofexistingTreasury securitiesarefromtheTreasurysMonthlyStatementofthePublicDebtasofOctober31,2012. Weassumethatanypurchasesinthesecondarymarketinatargetedbuckethaveanaverage couponrateequivalenttotheaveragecouponofTreasurysecuritiesinthemarketwith remainingmaturityinthisbucket.Asaresult,wecalculatethecurrentmarketvalueofthe securitiestocomputetheimpliedpremium.Reinvestmentofmaturingsecurities,however,is doneatauction,andweassumethatnewlyauctionedsecuritiesareissuedatpar,and thereforehavenopremiumassociatedwiththem.Forreinvestment,weprojectfuturecoupon ratesonnewlyissuedTreasurysecuritiesusingaregressionbasedtermstructuremodelas outlinedinAppendix2. ForholdingsofMBS,weseparateMBSpurchasedduringthefirstlargescaleassetpurchase programfromNovember2008toMarch2010andthereinvestmentpolicythroughOctober 2012,andthoseprojectedtobereinvestedandpurchasedin2013andbeyond.Thisdistinction isimportantbecausethecouponsonMBSpurchasedundertheassetprogramaregenerally higherthanthecurrentproductionMBS.TheMBScurrentlyheldontheFederalReserves balancesheethavecouponsthatrangefrom2.5to6.5percent.Thehighercouponsecurities tendtohavehigherpremiumsassociatedwiththem.MBSreinvestmentisassumedtotake placeincurrentcouponsecurities,whichhavebeenpurchasedatapremiumthatisassumedto be4percentabovefacevalue. 3.4.2 Interest expense OvermuchoftheFederalReserveshistory,interestexpensehasbeenmodest.Interest expensederivesfrominterestbearingliabilities,inparticulartheforeignreverserepurchase agreementpoolandreservebalances.Overthepastdecadeorso,theforeignrepopoolhas averagedroughly$50billionandpaysinterestatarateconsistentwithovernightreporates. Asaresult,thisinterestexpenseisrelativelysmall.Asmentionedabove,priorto2008,the FederalReservedidnothavetheauthoritytopayinterestonreservebalances.Currently, althoughreservebalancesarequiteelevated,at$1.5trillion,theIOERrateis25basispointsat anannualrate,whichimplieslessthan$4billionpaidininterestoverthecourseofthisyear.

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Interestratesareprojectedtorise,however,andweassumethattheIOERratewillbeequalto thefederalfundsrate.34Asaresult,interestexpensewillrise.But,intheprojections,reserve balancesareprojectedtodecline,sotheneteffectoninterestexpensedependscriticallyon thetimingoftheriseininterestratesandthedeclineinreservebalances. 3.4.3 Capital gains or losses FederalReserveBankaccountingonlyrealizesgainsorlossesontheSOMAportfolioifa securityissold,andhistorically,theFederalReservesoldsecuritiesinfrequently.35In2011, MEPsalesrecordedaslightcapitalgain.Inaddition,prepaymentsonMBSresultina realizationofagainoralossonthatsecuritybasedontheamountoftheprepayment.36For theseprojections,wecalculatecapitalgains(losses)asthemarketvalueofthesecuritiesbeing soldminustheirparvalueandunamortizednetpremiums.Themarketvalueiscalculatedusing theyieldcurvesanddiscountedcashflowmethodologydescribedinAppendix2.In determiningtheFederalReservesincomeinagivenperiod,aftertheearningsandexpenses discussedabovearecalculated,capitalgains(losses)areadded. 3.4.4 Other items, dividends, transfers to surplus, and remittances to the Treasury Thevariousothercomponentsthatcontributetonetincomearesmallandnotedin Appendix1.Twoadditionaladjustmentstonetincomearemadebeforethecalculationof remittancestotheTreasuryiscomplete.Asnotedabove,theFederalReserveisstatutorily requiredtopaydividendstomemberbanks.Inaddition,theReserveBankstransferfundstoa surpluscapitalaccounttoensurethatsurplusalwaysequalscapitalpaidin.Remittancestothe Treasuryinanyperiodarecalculatedasallremainingnetincomeaftertheseadjustments. RemittancestotheTreasury,however,canneverbenegative.Asnotedabove,ifthereisan operatinglossinsomeperiod,thennoremittanceismadeuntilearnings,throughtime,have

Thisisasimplifyingassumption.Inthefuture,dependingontheoperatingframeworkandotherfactors,the IOERratecouldbeabove,equal,orbelowthefederalfundsrate. 35 TheassetsheldbytheSOMAportfoliothataredenominatedinforeigncurrenciesarerevalueddailyand,asa result,canexperiencegainsandlosses.Thesechanges,however,aresmallcomparedtothesizeofthebalance sheetandnetincome. 36 Dollarrolltransactions,whichinvolvebothapurchaseandasaleofMBScanalsoresultinrealizedgainsor losses.

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beensufficienttocoverthatloss.Thevalueofthefutureearningsthatwillberetainedtocover thislossisadeferredasset.

4 Projections
Inthissection,webeginwiththreeoptionsfortheprojectionofthebalancesheet:no purchasesin2013,$500billioninpurchasesin2013;and$1trillioninpurchasesin2013.These baselinescenariosprovideausefulguidetohowtheFederalReservesbalancesheetmight evolveunderarangeofpossibleassumptions.Next,weexamineascenariowhereinterest ratesareuniformly100basispointshigherthaninthebaselineafterliftoff.Althoughthis shockparticularlytheparallelshiftisanunlikelyoutcome,wepresentittoshowtheinterest ratesensitivityoftheportfolio.Aswillbeshown,thecontoursoftheprojectionsintheshock scenarioaresimilartothoseunderbaselineassumptionsforinterestrates,butthesizeof capitallossesislarger,interestexpenseishigher,andremittancesarethereforelower.Finally, wediscussascenariowhereinterestratesare100basispointslowerthaninthebaselineafter liftoff.Again,thecontoursoftheprojectionsaresimilartothebaseline,withlossesand interestexpensesomewhatlower.Westressagainthattheseprojectionsaretheresultofthe underlyingassumptionsmadeaboutinterestratesandpolicydecisionsand,asaresult,arenot forecaststhemselves.Thepointoftheanalysishereistoestablishaframeworkforsuch projections,anddifferentassumptionswould,ingeneral,resultindifferentprojections.

4.1 Baseline scenarios

4.1.1 Balance sheet Figures10and11presenttheprojectionsofkeybalancesheetlineitemsunderourthree baselinescenarios.AsshowninthetopleftpanelofFigure10,SOMAholdingsmoveupslightly throughtheendof2012reflectingthe$40billionpermonthpurchasesofMBS.In2013,under withnofurtherpurchases(thesolidline),theportfolioremainsfairlysteadyatitsend2012 level.37With$500billionor$1trillioninfurtherpurchases(thebluedashedandreddotted

TherearesomeagencyMBSpurchasedduring2012thatsettlein2013,causingtheSOMAportfoliotoincrease slightlyduring2013.

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lines,respectively),theportfoliorisesthrough2013,growingat$85billionpermonth.The peaksizeoftheportfolioreflectsthesizeofthepurchaseprogram:withnofurtherpurchases, theportfolioreaches$2.75trillion,with$500billion,$3.25trillion,andwith$1trillion,$3.75 trillion.Thelevelofreservebalancesreflecttheassetprograms,withreservebalancestopping outat$1.7trillion,$2.2trillionand$2.7trillioninthezero,$500billion,and$1trillionasset purchaseprograms,respectively.Afterpurchasesend,undertheassumptionthattheFOMC beginstoallowallassetholdingstorollofftheportfolioasthefirststepintheexitstrategy, withthetimingimpliedbytheinterestrateprojections,SOMAholdingsbegintodecline. NoticethatSOMATreasuryholdings,thetoprightpanel,remainconstantevenwhenrolloff begins.ThisfactisaresultoftheMEPreducingholdingsofshorterdatedTreasurysecuritiesto nearzero.MBSholdings,thebottomleftpanel,ontheotherhand,begintocontract. BeginninginSeptember2015,againconsistentwithourassumptionsabouttheexitstrategy, MBSsalesbegin,andtheseholdingsfalltozerobyAugust2019.Inthenofurtherpurchases scenario,thesizeofthebalancesheetisnormalizedinApril2018(32monthsaftersalesbegin), whileinthe$500billionand$1trillionpurchasescenarios,normalizationoccursinOctober 2018(38months)andFebruary2019(42months),respectively.38 ThereductioninthesizeoftheSOMAportfolio,alongwiththeprojectedgrowthofReserve BankcapitalandFRnotes,resultsindeclinesinthelevelofreservebalances,showninthe bottomrightpanelofFigure11.Asdescribedabove,weassumethatreservebalancesarenot allowedtofallbelow$25billion.Therefore,byearly2019inallscenarios,theseprojections assumethattheDeskagainstartstoreinvestmaturingTreasurysecuritiesandbegins purchasesofTreasurysecurities.Afterthispointintime,theSOMAportfolioexpandsinline withFRnotesandcapitalandreservebalancesremainconstantandunconventional monetarypolicyhasessentiallyunwound.

AlthoughthetimingofthenormalizationofthebalancesheetisslightlybeyondwhattheCommitteeanticipated intheexitprinciples,thesaleswindowweassumecouldbeshortenedandthenormalizationdatecouldfallwithin thewindow.Theeffectofsellingoverashortertimeperiodonincomeisambiguous:whileacceleratedsales wouldtendtoincreaserealizedlosses,interestexpenseshouldfallasreservesdecline.

38

27

4.1.2 Income Figure12showsthepathofReserveBanknetincomeunderthethreebaselinescenarios. BecauseofthelargesizeoftheSOMAportfolio,interestincomeiselevatedthrough2015inall scenarios,withthelargerportfolioshavinghigherinterestincome.AstheSOMAportfolio beginstocontractwiththeassumedstepsintheexitstrategy,interestincomedeclinesthrough mid2018.Afterreservebalancesreach$25billion,Treasurypurchasesresume,expandingthe portfolio,causinginterestincometorise. Asnotedabove,interestexpensereflectsboththelevelofthefederalfundsrateandthelevel ofreservebalances.ThefederalfundsrateintheBlueChipforecastbeginstorisein2015,and interestexpenseriseswithit.However,in2016,interestexpensebeginstomoderate,asthe declineinreservebalancesmorethanoffsetstheriseinthefederalfundsrate. Intermsofcapitalgainsorlosses,TreasurysecuritiessalesconductedundertheMEPresultina smallgainbecauseofthelowlevelofmarketinterestratesin2012andtherelativelyhigher coupononthesecuritiessold.39Duringtheexitstrategy,however,MBSsalesresultinrealized losses.Overthefouryearsalesperiod,September2015toAugust2019,theselossesaverage roughly$18billionperyearacrossallthreescenarios.Thisamountmayseemnotablebut shouldbecomparedtothecumulatedearningsfromthelargerportfolio. Onnet,remittancestotheTreasuryremainelevatedbyhistoricalstandardsthrough2015,but thendecline.Forthescenarioswithadditionalpurchasesin2013,remittancesfalltozerofora numberofyears,reflectingsomerealizedlossesassociatedwithsalesandhigherinterest expense,andadeferredassetisrecorded.Thelargertheprogram,thelargerthesalesand interestexpense,andsothelargeristhepeakdeferredasset. Forthe$1trillionpurchasescenario,thereisadeferredassetthatlastsforfouryearsandthat peaksat$40billion.Forcomparison,thesurpluscapitalaccountthatis,retainedearningsis aboutthesamesizeasthispeak,andtheaverageannualremittancestotheTreasuryoverthe projectionperiodisslightlylarger.Oncesalesarecompletedandtheportfolioreachesits
ThevastmajorityofsecuritiessoldundertheMEPwereshortdatedcoupons,notbills.

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28

steadystategrowthpath,remittancestotheTreasuryriseslowlyastheportfolioexpandsand interestincomerises.Remittancesin2025arecloseto$45billion. Whencomparingthecumulativeremittancesgeneratedfromalternateprograms,the$1 trillionprogram,whichresultsinthelargestdeferredasset,resultsincumulativeremittances thatareroughly$60billionbelowthescenariowithnofurtherpurchases,orroughly$5billion lessonaverageperyear.Ofcourse,theoveralleffectonthefederalgovernmentsfinancesis morecomplicated.Forexample,iftheseadditionalassetpurchasesprovidemeaningful economicstimulus,theincreaseingovernmentrevenuesfromfastereconomicgrowthcould morethanoffsetthereductioninremittances.Further,iftheassetpurchaseslowerinterest rates,theinterestexpenseofthefederalgovernmentislower. Asdiscussedabove,onlyrealizedgainsorlossesaffecttheFederalReservesincome. Nevertheless,giventhelargeSOMAportfolioandtheprojectedriseininterestrates,underthe baselineprojections,theportfolioisinanunrealizedlosspositionbeginningin2014.This unrealizedlosspositioncontinuestogrowthrough2017,butsubsequentlydiminishesasthe portfolioshrinksthroughredemptionsandsales.

4.2 Higher interest rates

PolicymakershavealsodiscussedtheinterestratesensitivityoftheSOMAportfolioandthe implicationsoflargeincreasesininterestratesonFederalReservenetincome.40Toexplore thispossibility,asshowninFigure9underthehigherinterestratescenario(thedashedline), thefederalfundsrateandtenyearTreasuryyieldriseatafasterpaceatliftoff,andafterone yearare100basispointshigherthanthebaselineratesovertheremainderoftheprojection period.Onecouldimagineanincreaseininflationorinflationexpectationscouldleadtosucha result;modelingthistypeofeconomicenvironmentisbeyondthescopeofthispaperandthe shockisusedsolelytodemonstrateintheinterestratesensitivityoftheportfolio.Wenote,
Forexample,theminutestotheDecember2012FOMCmeetinghighlightedthat[p]articipantsalsodiscussed theimplicationsofcontinuedassetpurchasesforthesizeoftheFederalReservesbalancesheet.Dependingon thepathforthebalancesheetandinterestrates,theFederalReservesnetincomeanditsremittancestothe Treasurycouldbesignificantlyaffectedduringtheperiodofpolicynormalization,availableat http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20121212.pdf.
40

29

however,thatthisshockisbroadlyconsistentwiththetenhighestinterestrateprojections fromrespondentstotheBlueChipsurvey.Inotherwords,theseinterestratesareatthehigh endofmarketexpectations,butareseenasplausibleoutcomesbyprofessionalforecasters.In thebaselineinterestrateprojection,thetenyearTreasuryyieldrisesby2percentagepoints betweenend2014andend2016.Bycontrast,the100basispointshockimpliesthetenyear Treasuryyieldisincreasingby3percentagepointsoverthesetwoyears. Thereareacoupleofwaystoputthesizeofthisshockinperspective.Tostart,thissizeshock isabovethatexpectedbytherespondentstotheDecember2012BlueChipsurveywiththetop tenhighestinterestrateexpectations(roughly20percentofthesample),andthusisprobably comfortablyabovemostmarketparticipantsinterestrateprojections.Inaddition,fora historicalcomparison,from1978topresent,thestandarddeviationofthetwoyearchangein the10yearTreasuryyieldis1.6percentagepoints.Asaresult,thishigherinterestrate scenarioshouldbeseenasasomewhatunlikelyscenario,butnotanimplausibleone.Of course,totheextentthatinflationexpectationshavebecomebetteranchoredthroughtime, thisincreaseininterestratesmaybeevenlessprobablethanthehistoricalrecordmaysuggest. TheinterestrateshockdoesnotchangethebroadcontoursoftheFederalReservesbalance sheet,asshowninFigure13.Thehigherinterestratepathdoes,however,changetheincome projectionsnotably,andasaresult,leadstoadifferentpathofremittancestoTreasury. Broadlyspeaking,thehigherinterestratepathreducesremittancesasinterestexpenserises andlossesonsecuritiessalesgrow.Inthelongerrun,afterthesizeofthebalancesheet normalizes,thehighercouponrateonTreasurysecuritiespurchasedtokeeppacewiththe growthoftheFederalReservesbalancesheetactuallypushesupremittances. ThespecificsoftheincomeprojectionswithhigherinterestratesareshowninFigure14. SOMAinterestincomeremainssimilartothebaselinebecausethesecuritiesintheSOMA portfoliohavealreadybeenpurchasedandtheircouponsarefixed.However,interestexpense becomesgreateroncethefederalfundsrateliftsofffromthelowerboundbecauseofthe higherinterestratepath.Inaddition,becausesalesofMBSoccurwhenlongerterminterest ratesarehigherthaninthebaseline,realizedcapitallossesaresomewhatgreater.Overall,in 30

thescenariowithnoadditionalassetpurchasesin2013,thehigherinterestratescause remittancestotheTreasurytofalltozeroandasmalldeferredassetiscreated.Inthescenario with$1trillionadditionalassetpurchasesin2013,inthehigherinterestratescenario,the deferredassetpeaksat$125billion,substantiallyhigherthanunderthebaseline.Moreover, remittancestotheTreasuryarehaltedfor6years.Thisreductioninearningsinthisscenario reflectstheinterestrateriskthattheFederalReserveistakingonwithassetpurchases.More purchasestendtoleadtolargerrealizedlosses,andthelossesareevenlargerunderthehigher interestratescenario.Forcomparison,however,inthehigherinterestratescenario, cumulativeremittancesareonlyabout$45billionlowerthaninthescenariowithoutthe interestrateshock.Underallscenarios,remittancestotheTreasuryresumebyend2022.As notedabove,totheextentthatthepoliciesareeffectiveinstimulatingtheeconomy,overall governmentrevenueswouldbeboostedonnet,despitethesomewhathigherlossesatthe FederalReserve. Theseoutcomes,however,shouldbeviewedinalongertermcontext.Overall,averageannual remittancestotheTreasuryeveninthisshockscenarioremainabovetheaverageannual remittancesof$25billionrecordedpriortothecrisis.

4.3 Lower interest rates

JustasitispossibleforratestobehigherthanprojectedbytheBlueChipconsensusforecast, ratesmaybelowerthantheconsensusforecast.Inordertocharacterizethispossibility,Figure 15displaysthefederalfundsand10yearTreasuryyieldundertheassumptionthattherisein ratesisneitherashighnorasfastasinthebaselineconsensusforecast,andinthelongrun, ratesare1percentagepointlowerthaninthebaseline.Possiblescenariosthatcouldproduce thisoutcomethroughthemediumrunincludeaslowerorweakerrecoverythancurrently expectedbymarketparticipants.Ratherthanrisingby200basispointsinthelongerrun,the 10yearyieldmovesuponly100basispoints,amodestlevelcomparedtolongerrunaverages. Thispathisbroadlyconsistentwiththetenlowestinterestrateprojectionsfromthe respondentsoftheBlueChipsurvey.

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AsshowninFigure16,andsimilartothehigherinterestrateshock,thelowerinterestrate shockdoesnotchangethebroadcontourofthebalancesheetprojection.Nevertheless,the incomeprojectionandthereforeremittancestotheTreasurydoesmateriallychange,asshown inFigure17.Ingeneral,thelowerinterestratepathmitigateslossesfromsalesofagencyMBS anddampensexpensefromreservebalances,boostingremittancesrelativetothebaselineto somedegree.Asaresult,regardlessoftheamountofpurchasesin2013,remittancestothe Treasurystaypositiveinallyearsoftheprojectionandnodeferredassetisrecordedonan annualbasis.Mirroringtheresultsinthehigherinterestratescenarios,inthelongerrun,the lowercouponrateonTreasurysecuritiespurchasedtokeeppacewiththeexpansionofthe balancesheetdepressesremittancesrelativetothebaselinecase.However,despitethelower remittancesattheendoftheprojectionperiod,averageannualremittancesintheprojection stillremainwellabovetheaverageannuallevelbeforethecrisis.

5 Conclusion
Inthispaper,wehaveoutlinedthemechanicsofandprojectionsfortheFederalReserves balancesheetandincome.Underthebaselineprojections,derivedfrompubliclyavailable forecastsabouttheeconomyandpublicstatementsbytheFOMC,theFederalReserves balancesheetissubstantiallylargerthanithadbeenhistoricallyforsomeyearsuntil contractinggraduallyduringtheexpectedexitperiod,andonlyreturningtoitslongrungrowth pathinlate2018orearly2019.Thisresult,ifitisexpectedbymarketparticipantsandwereto berealizedinpractice,wouldimplythatunconventionalmonetarypolicyactionswouldbe holdinginterestratesdown,tosomedegree,foranumberofyears.TheFederalReserves incomeandremittancestotheTreasuryareprojectedtoremainathistoricallyelevatedlevels forafewmoreyears,reflectingtherelativelyhighyieldsearnedonlongertermTreasury securitiesandMBS.However,remittancessubsequentlydeclineforatime.GiventheFOMCs statedplantosellMBSatthetimethatpolicyaccommodationisbeingremoved,somelosses areprojectedtoberealizedonthosesales.Moreover,theelevatedlevelofreservebalancesis projectedtoleadtoincreasinginterestexpenseforsometime.Takentogether,remittancesto Treasuryareprojectedtofalltoalowlevelortobehaltedforafewyearsandadeferredasset 32

willbebookedontheFederalReservesbalancesheet.Subsequently,theFederalReserves incomeisprojectedtoreturntoitslongertermtrendandremittancestotheTreasuryrebound. Todemonstratetheinterestrateriskontheportfolio,andtounderscorethefactthatthese projectionsarenotforecastsperse,butrather,theresultofasetofassumptions,weconsider howincomemayevolvewitha100basispointshockupwardsordownwardstothebaseline interestratepaths.Overall,higherinterestratesresultinhigherrealizedlossesonMBSsales andhigherinterestexpense,bothofwhichcontributetoalargerdeferredasset,allelseequal. Ontheotherhand,lowerinterestratesgeneratelowerrealizedlossesandlowerexpense,and consequently,nodeferredassetisrecorded.Inallofthesimulations,however,lookingat cumulativeremittancestotheTreasuryovertheperiodoftheuseofthebalancesheetasatool forpolicysuggeststhatFederalReserveearningsareboosted,onnet,fromtheseactions.That resultsuggeststhattheFederalReserveisnotimposingacostontheTreasury,butinstead, howeverincidentally,providingadditionalrevenues.Ofcourse,anyandalloftheresultsarea reflectionoftheassumptions,andnoneoftheassumptionsusedintheanalysisreflectofficial viewsoftheFederalReserve.Rather,theassumptionsarederivedfrompubliclyavailable information.

33

Bibliography
BoardofGovernorsoftheFederalReserveSystem.1976.BankingandMonetaryStatistics, 19141941. Carpenter,Seth,Ihrig,Jane,Klee,Elizabeth,Boote,Alexander,andQuinn,Daniel.2012.The FederalReservesBalanceSheet:APrimerandProjections,FinanceandEconomicsDiscussion Seriesno.201256,FederalReserveBoard,August. Chung,Hess,Laforte,JeanPhilippe,Reifschneider,David,andWilliams,JohnC.2011.Have WeUnderestimatedtheLikelihoodandSeverityofZeroLowerBoundEvents?FederalReserve BankofSanFranciscoWorkingPaper201101,January. Edwards,CherylE.1997.OpenMarketOperationsinthe1990s,FederalReserveBulletin,p. 859874. FederalReserveBankofNewYork.2011.DomesticOpenMarketOperationsin2010, availablefordownloadat http://www.newyorkfed.org/markets/Domestic_OMO_2010_FINAL.pdf Garbade,KennethD.,Partlan,JohnC.,andSantoro,PaulJ.2004.RecentInnovationsin TreasuryCashManagement,CurrentIssuesinEconomicsandFinance,FederalReserveBankof NewYork,vol.10,no.11,November. Gurkayank,Refet,Sack,Brian,andWright,Jonathan.2007.TheU.S.Treasuryyieldcurve: 1961tothepresent,JournalofMonetaryEconomics,p.22912304,November. Ihrig,Jane,Klee,Elizabeth,Li,Canlin,Schulte,Brett,andWei,Min.2012.Expectationsabout theFederalReservesBalanceSheetandtheTermStructureofInterestRates,forthcoming FederalReserveFinanceandEconomicsDiscussionSeriespaper. Judson,Ruth,andPorter,Richard.1996.TheLocationofU.S.Currency:HowMuchis Abroad?,FederalReserveBulletin,vol.82,p.883903,October.

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Meltzer,Allan.2010.AHistoryoftheFederalReserve,Volume2,19511986,Universityof ChicagoPress. Rudebusch,GlennD.2011.TheFedsInterestRateRisk,EconomicLetters,FederalReserve BankofSanFrancisco,April11.

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Appendix 1: Overview of selected balance sheet items and assumptions underlying the balance sheet and income projections
Thisappendixprovidesdetailsabouttheforecastingprocedureforeachbalancesheetitem. ThosenotspecificallydiscussedareheldattheirlevelasofOctober31,2012.

6 Balance sheet
6.1 Treasury securities
SOMATreasuryholdingsareassumedtoevolvethroughacombinationofoutrightpurchases andoutrightsalesinthesecondarymarket,reinvestmentatauction,andmaturities. Outrightpurchasesforthe$667billionMaturityExtensionProgram(MEP)havethe maturitybucketsandtargetsannouncedbytheFederalReserveBankofNewYork: MaturityExtensionProgrampurchasedistribution (percent) Nominalcouponsecurities TIPS 810 1020 2030 68years years years years 32 32 4 29 3 Outrightpurchasesin2013aresimulatedaccordingtothematuritybucketsandtargets asannouncedbytheFederalReserveBankofNewYork:
2013Treasurypurchasesdistribution(percent) Nominalcouponsecurities 4.75 5.757 710 1017 1730 5.75 years years years years years 12 16 29 2 27

TIPS

44.75 years 11

Securitiesassumedtobeavailableforpurchasereflectthoseoutstandingonthe MonthlyStatementofthePublicDebtasofOctober31,2012aswellasforecastsfor futureissuance.HoldingsofanyparticularCUSIParelimitedto70percentoftheCUSIP outstanding,consistentwiththeDeskscurrentpractice. ThetotalparvalueofTreasurysecuritiesoutstandingreflectstheCongressionalBudget Offices(CBO)projectionsfortotaldebtheldbythepublic. 36

TheaveragematurityofTreasurydebtextendsfromitscurrentvalueof60monthsto 70months,consistentwithobservationsmadebytheTreasuryBorrowingAdvisory CommitteeinNovember2011andAugust2012.41 Theproceedsfrommaturingsecuritiesarereinvestedatauctionatratesconsistentwith theBlueChipforecastforinterestrates,asdiscussedinAppendix2.Auctionsizesare determinedbytheamountoftotaldebtnecessarytomatchCBOprojectionsandfollow adistributiondeterminedbyactualauctionsthroughOctober2012.Thisdistributionis thenalteredasnecessarytoextendtheaveragematurityofTreasurydebt.TheCBOs debtprojectionsalongwiththematuritydistributionofsecuritiesauctionedinOctober 2012aresummarizedinthetablesbelow.

Year

CBOdebt heldby thepublic ($Billion) 9,019 10,128 11,242 11,945 12,401 12,783 13,188 13,509 13,801 14,148 14,512 14,872

Buckets

October2012 Initial Issuanceby sharesof bucket($ issuance Billion) 160 128 112 25 35 32 35 29 21 13 0.27 0.22 0.19 0.04 0.06 0.05 0.06 0.05 0.04 0.02

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

1month 3month 6month 1year 2year 3year 5year 7year 10year 30year

Source: Wrightson,AuctionCalendar

Source:CBO,Jan.2012TheBudgetandEconomicOutlook:FiscalYears2012to2022

6.2 Agency securities

Theagencysecuritiesportfolioisassumedtoevolveduetoacombinationofpurchases, sales,andprepayments. ConsistentwiththeFOMCsstatementaftertheSeptember2011FOMCmeeting, principalpaymentsfromSOMAagencyMBSanddebtandarereinvestedinagencyMBS. WeuseacurrentcouponmodeltoestimatethecoupononnewlypurchasedMBS
41

Refertohttp://www.treasury.gov/presscenter/pressreleases/Pages/tg1349.aspxand http://www.treasury.gov/presscenter/pressreleases/Pages/tg1665.aspx.

37

securitiesbasedontheconsensuslongrunBlueChipforecastforthe10yearTreasury rateand30yearfixedratemortgagerate,reviewedinAppendix2. PrepaymentsonsettledagencyMBSholdingsasofOctober31,2012aregeneratedby applyingtherealizedprepaymentrateontheSOMAholdingsofMBSfromJune2010to July2011(theperiodwhentherewerenonewholdingsofMBSsettlingintheSOMA portfolio)onmonthlyholdingsfromSeptember2012tothefederalfundsliftoff,in March2015.Thisprepaymentrateisnotablyfasterthanwhatwouldbepredictedusing thestandardPSAprepaymentmodel,likelyaresultofthehistoricallylowlevelof mortgagerates.Afterthefederalfundsrateliftsoff,wegraduallysmooththe prepaymentratebacktothelongrunPSAmodeloverafiveyearperiod. PrepaymentsonanticipatedfuturepurchasesofagencyMBSfollowthelongrunPSA modelforthelifeofthesecurity. Salesofagencysecuritiesbeginsixmonthsafterthefirstincreaseinthefederalfunds rateandlastforfouryears.ThistimingisconsistentwiththatlaidoutintheJune2011 FOMCMinutes;however,theexacttimingismerelyillustrativeandchosensoastobe easilyimplementableinourprojections. Undertheseassumptions,andgiventhematurityscheduleforagencydebtsecurities, thevolumeofsalesnecessarytoreduceholdingsofthesesecuritiestozerooverthe fouryearperiodonlyrequiresasixmonthperiodofminimalsalesneartheendofthose fouryears.

6.3 Premiums and discounts

FederalReserveaccountingrecordsalldomesticsecuritiesholdingsatfacevalue,rather thanatmarketvalue.ExceptfortherolloverofmaturingTreasurysecurities,new purchasesofsecuritiesareconductedintheopenmarketatmarketprices.Ifasecurity ispurchasedformorethanitsfacevalue,thedifferencebetweenthepurchaseprice andthefacevaluethepremiumonthatsecurityisrecordedseparatelyasanasset onthebalancesheet.Likewise,ifasecurityispurchasedforlessthanitsfacevalue,the differencebetweenthepurchasepriceandthefacevaluethediscountonthat securityisrecordedasaliabilityonthebalancesheet.Reservebalancesincreaseby thepurchasepriceofthesecurity,thatis,thefacevalueplusthenetpremium (premiumsnetofdiscounts). Atmaturityofthesecurity,theFederalReservewillonlyreceivethefacevalue,sothe premiumsanddiscountsmustbeamortizedovertheremainingtermofthesecurity. U.S.TreasurysecuritiesandagencydebtsecuritiesheldbytheFederalReserveBanks areamortizedlinearlyovertheremainingtermofthesecurity.Intheaccounting treatmentofagencyMBSpremiums,theamortizationscheduleforMBSisbasedonan effectiveyieldcalculation,whichresultsinaconstantrateofreturnduringthetermof 38

thesecurity.Intheanalysisthatfollows,however,wesimplifythisassumptionand implementagencyMBSamortizationusingthepathofanticipatedpaydownsofagency MBS. Asofyearend2011,therewere$88billioninunamortizedpremiumsand$1billionin discountsassociatedwithholdingsofTreasurysecuritiesand$12billioninunamortized premiumsand$1billionindiscountsassociatedwithholdingsofagencyMBS.42Weuse straightlineamortizationofthesepremiumsanddiscountsovertheexpectedlifeof currentSOMAholdings.WederivenewpremiumsanddiscountsfromoutrightTreasury purchasesbyusingthedifferencebetweentheassumedcouponofthesecuritybeing purchasedandthecorrespondingmarketinterestrate,asgivenbytheyieldcurve estimatesreviewedinAppendix2. WeassumethatagencyMBSarepurchasedataprice4percentaboveparvalue,and thereforebooksomepremiumsontheseassetpurchases.Basedonthecalculationsfor thepurchasepricesofTreasurysecurities,weestimatethatthereareapproximately $60billioninpremiumsassociatedwithTreasurysecuritiespurchasesoverthecourseof theMaturityExtensionProgramand$24billioninpremiumsper$500billionofnew purchasesin2013.

6.4 Lending
Sinceitsinception,theFederalReservehashadtheauthoritytolendtodepository institutions.Priortothefinancialcrisis,however,borrowingfromtheFederalReserve tendedtobequitesmall,typicallylessthanacouplehundredmilliondollarsoutstanding perday.Duringthefinancialcrisis,lendingbytheReserveBanksgrewsignificantly,at onepointexceeding$1trillionoutstanding.43LendingbytheFederalReserveincreases reservebalances,allelseequal,becauseinlendingtoadepositoryinstitution,the ReserveBankdirectlycreditsthatinstitutionsreserveaccount.Asaresult,reserve balancesroseaslendingincreasedduringthefinancialcrisis.Theloantotheinstitution isthecorrespondingassetontheFederalReservesbalancesheet. Wemakethesimplifyingassumptionthatalldiscountwindowlendingoverthe projectionperiodiszero.

RefertotheCombinedFinancialStatementoftheFederalReserveSystem,availableat http://www.federalreserve.gov/monetarypolicy/bst_fedfinancials.htm. 43 Includedinthisnumberareprimary,secondaryandseasonalloans;termauctioncredit;theprimarydealerand otherbrokerdealercredit,creditextendedtoAIG,netportfolioholdingsofCommercialPaperFundingFacility, andtheoutstandingprincipalamountofloansextendedbytheFederalReserveBankofNewYorktoMaidenLane, MaidenLaneII,andMaidenLaneIII.

42

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6.5 TALF LLC

AssetsheldbyTALFLLCconsistofinvestmentsofcommitmentfeescollectedbytheLLC andtheU.S.Treasurysinitialfunding.Inthisprojection,theLLCdoesnotpurchaseany assetbackedsecuritiesreceivedbytheFederalReserveBankofNewYorkinconnection withadecisionofaborrowernottorepayaTALFloan. TheassetsheldbyTALFLLCremainneartheircurrentleveloflessthan$1.0billion through2014beforedecliningtozerothefollowingyear.

6.6 Maiden Lane LLC

TheassetsheldbyMaidenLaneLLCdeclinegraduallyovertimeandfalltozerobyearly 2015.

6.7 Reserve balances

Reservebalancesaretheresidualofassetslessotherliabilitieslesscapitalinthebalance sheetprojection.Thatsaid,aminimumlevelof$25billionissetforreservebalances, roughlyequivalenttothelevelofreservebalancesbeforethestartofthefinancialcrisis. Tomaintainreservebalancesatthislevel,firstTreasurybillsarepurchased.Purchases ofbillscontinueuntilthesesecuritiescompriseonethirdoftheFederalReservestotal Treasurysecurityholdingsabouttheaveragelevelpriortothecrisis.Oncethislevelis reached,theFederalReservebuysnotesandbondsinadditiontobillstomaintainan approximatecompositionoftheportfolioofonethirdbillsandtwothirdscoupon securities.Ingeneral,increasesinthelevelofFederalReserveassetsaddreserve balances.Bycontrast,increasesinthelevelsofliabilityitems,suchasFederalReserve notesincirculationorotherliabilities,orincreasesinthelevelofReserveBankcapital, drainreservebalances.

6.8 Reverse repurchase agreements

TheFederalReserveconductsreverserepurchaseagreements(reverserepos,orRRPs) bysellingsecuritiestocounterpartieswhosellthesecuritiesbacktotheFederalReserve onastatedfuturedate.Currently,thelargestportionofoutstandingreversereposis withforeigncentralbanksthatholddollarsintheiraccountsattheFederalReserve BankofNewYork.KnownastheforeignRPpool,asofendMay2012,therewasa littlelessthan$100billioninforeignRPpooltransactionsoutstandingontheFederal Reservesbalancesheet. InadditiontotheforeignRPpool,beforethefinancialcrisis,theFederalReserve occasionallyengagedinreversereposwithprimarydealerstodrainreservebalances. Thesetransactionsareconceptuallydistinctfromtheserviceprovidedbytheforeign 40

repopool;inparticular,theyareintendedtobepartofopenmarketoperationsand thereforepartoftheconductofmonetarypolicy.Sincelate2009,theFederalReserve BankofNewYorkhastakenstepstoexpandthetypesofcounterpartiesforreverse repostoincludeentitiesotherthanprimarydealers,inordertoprepareforthe potentialneedtoconductlargescalereverserepurchaseagreementtransactions.

6.9 Currency
FederalReservenotesincirculationareassumedtogrowatthesamerateasnominal GDP.WeusetheconsensusBlueChipforecastsforrealGDPgrowthandthepricelevel toformtheforecastfornominalGDPthrough2025.Becausethisisanannualforecast, weusetheannualgrowthrateastheannualizedquarterlygrowthrateforthe2ndand 3rdquartersofeachyear,andtheninterpolategrowthratesforthe1stand4thquarters oftheyear.ThetablebelowsummarizestheBlueChipprojectionsfornominalGDP growth.
Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 BlueChip nominalGDP growth forecast 4.0% 4.2% 5.0% 5.2% 5.1% 5.1% 4.9% 4.7% 4.7%

Source:BlueChip,December2012

6.10 Reverse Repurchase Agreements (RRPs)

TheFederalReserveconductsRRPswithforeignofficialaccounts,international accounts,andothercounterparties.ThevolumeofRRPsthatisconductedwithforeign officialandinternationalaccountsisassumedtostayconstantatitsmostrecentlevelof approximately$98billioninMay2012.Theportionthatisconductedwithothersis assumedtostayatzeroovertheprojectionperiod.

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6.11 Other liabilities

Priorto2008,theleveloftheTGAwasfairlyconstantnear$5billion.44Sincethattime, however,theTreasuryhasmaintainedessentiallyitsentirecashbalanceintheTGAand theTGAhasbeenvolatile,reflectingtheebbsandflowsoftheTreasuryscash managementasborrowingandtaxreceiptsincreasethecashbalanceandvarious outflowsreducethecashbalance.45 Fortheprojections,weassumethattheTGAfollowstherecenthistoricalpatterninthe nearterm,andthendropsto$5billionaftertheliftoffofthefederalfundsrate. Thereareasetofotherliabilitiesthatwedonotdiscussindetailbecausetheyare,in general,eithersmallornotparticularlyrelevantforthepurposesoftheseprojections. MorediscussionoftheFederalReservesbalancesheetisavailableontheBoardof Governorswebsite.46

6.12 Capital
FederalReservecapitalgrows15percentperyear,inlinewiththeaveragerateofthe pasttenyears.

6.13 Deferred Asset

IntheeventthataFederalReserveBanksearningsfallshortoftheamountnecessaryto coveroperatingcosts,paydividends,andequatesurplustocapitalpaidin,adeferred assetwillberecorded.ThisdeferredassetisrecordedinlieuofreducingtheReserve BankscapitalandisfoundontheliabilitysideofthebalancesheetasIntereston FederalReservenotesduetoU.S.Treasury.Thisliabilitytakesonapositivevalue whenweeklycumulativeearningshavenotyetbeendistributedtotheTreasury,while thisliabilitytakesonanegativevaluewhenearningsfallshortoftheexpenseslisted above.

7 Income
Associatedwiththebalancesheetprojectionsareincomeitems.Thoseitemsnot specificallydiscussedareassumedtogeneratenoincomeorexpense.

44 45

ForadiscussionofTreasurycashmanagementduringthisperiod,refertoGarbade,PartlanandSantoro(2004). RefertoFRBNY(2011),pages2829. 46 http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm

42

7.1 SOMA Interest Income

TheSOMAportfolioconsistsoffourtypesofsecurities:agencydebt,agencyMBS, Treasurybills,andTreasurycouponsecurities.SOMAinterestincomeisdefinedas holdingsmultipliedbytheirrateofreturnlessnetamortizationofpremiums. TheaveragecouponontheportfolioofcurrentagencyMBSholdingsisessentiallyfixed atitscurrentaveragecouponof4.19percentforsimplicity.Couponsonforecasted agencyMBSholdingsareestimatedusingthecurrentcouponmodelreviewedin Appendix2.Salesandprepaymentshaveacouponratereflectingtheweightedshareof allagencyMBSsecurities. TheaveragecoupononholdingsofTreasurysecurities,bycontrast,isnotfixed.The returnisaffectedbyredemptionsandpurchases.Threepointsarerelevant.First,we calculatetheaveragecouponoftheremainingstockofthesesecuritiesthroughthe projectionperiodusingCUSIPleveldata.Second,securitiespurchasedinthesecondary marketalsoaffecttheaveragecouponoftheTreasurysecuritiesholdings.Weassume thattheseoutrightpurchasesofsecuritieshaveacouponthatisdeterminedbya weightedaverageofthecouponsoneligibleTreasurysecurities.Theweightsare determinedbytheamountofeachsecuritythatisavailableforpurchaseafter accountingforselfimposedlimitsonSOMAholdings.Third,weassumethatthe FederalReservecontinuestorollovermaturingTreasurysecuritiesintonewsecurities purchasedatauctioninthesamematuritydistributionasitcurrentlyuses.Thecoupon forsecuritiespurchasedatauctionisdeterminedbytheinterestrateprojections. Asnotedabove,premiumsarelinearlyamortizedovertheexpectedlifeofthe securities.Inthesecalculations,aportionofthepremiumisamortizedeachyearand, consistentwithFederalReserveaccountingpractices,thisamortizationreducesinterest income.47Securitiespurchasedatadiscountaretreatedinananalogousway,and increaseinterestincome.

7.2 Other interest income

OtherinterestincomeitemsontheFederalReservesincomestatementinclude revenuefromdiscountwindowloansandotherloans.Mostofthetime,incomefrom theseitemsissmallcomparedtothatontheSOMAportfolio.However,reflectingthe FederalReservesactionsduringthefinancialcrisis,interestincomefromloansand otherassetswerenotable,althoughstillsmallerthanincomefromSOMAin2008and 2009,comprisingbetween15and30percentoftotalinterestincome.

Ifthesecurityissold,thetotalunamortizedpremiumassociatedwiththesecurityisaccountedforinthecapital gain(loss)lineoftheincomestatementintheseprojections.
47

43

Incomefromotherassetsiscalculatedusingthesimpleformulaofholdingsmultiplied byrateofreturn.Therateofreturnfordiscountwindowborrowingisassumedtobe50 basispointshigherthanthefederalfundsrate,consistentwiththespreadestablishedin February2010.TherateofreturnonTALFiscalculatedusingtheobservedrateof returnfromJanuary1,2011,toJune30,2011,of1.76percentatanannualrate.48Other assetshaveratesofreturnconsistentwiththeirownhistoricalratesofreturn.

7.3 Interest expenses

Twoprimarysourcesofinterestexpenseareforecastedinthismodel:interestexpense associatedwithreverserepurchaseagreements(RRPs)andinterestpaidonreserve balances.Tocalculatetheinterestexpenseonbothreversereposandreservebalances, thequantitiesoftheseliabilitiesfromthebalancesheetprojectionaremultipliedbythe projectedfederalfundsrateintheappropriatetimeperiod.

7.4 Capital gain (loss)

Inthisanalysis,capitalgains(losses)arerealizedduetoassetsales,whileunrealized capitalgains(losses)arecalculatedfortheportfolioasawhole.Theanalysisassumes thatthequantitiessoldarearepresentativeshareofthetotalholdingsunlessotherwise stated,andsolossesareproportionaltothetotallossposition.Realizedcapitalgains (losses)aredefinedtobethemarketvalueoftheassetatthetimeofthesalelessthe parvaluelessnetpremiumsamortizedduetosales.Unrealizedcapitalgainsare similarlydefinedasthemarketvalueoftheremainingholdingslessitsparvalueless unamortizednetpremiums. ThemarketvalueoftheSOMAportfolioisobtainedbyestimatingthepresent discountedcashflowsoftheassetsheldinSOMA.Adjustmentsaremadefor prepayments,purchases,andsales.Themethodologiesforderivingdiscountfactors andvaluingoftheportfolioaredescribedinAppendix2.

7.5 Miscellaneous items

Wehavemadesimplifyingassumptionsaboutotherincomeitems.Inparticular,non interestincomeisprimarilyfromforeignexchangetransactionsandfrompriced services.Duringtheheightofthefinancialcrisis,whentheleveloftheswaplines outstandingsurpassed$580billion,incomefromforeignexchangewascloseto$4

ThecalculationusestheaveragebalanceoftheTALFandtheinterestincomereportedintheMonthlyReporton CreditandLiquidityProgramsandtheBalanceSheet,October2011,p.27.

48

44

billion.Inprioryears,however,incomeonforeignexchangewasmoremuted.Priced servicesincome,primarilyfromcheckandotherpaymentsprocessing,wasalsoa traditionalsourceofincomefortheFederalReserve.Ascheckprocessingbecame increasinglyelectronic,incomefrompricedservicesdeclined.Asaresult,inour analysis,noninterestincomefromserviceincomeisingeneralsmallandsoissetto zeroineachyearoftheprojection. Wehavealsomadesimplifyingassumptionsontheremainingexpenseitems. Specifically,basedonrecentobservations,weassumefixedannualoperatingexpenses of$6billionperyear.Andfinally,consistentwiththerulesoutlinedintheFederal ReserveAct,dividendsareassumedtobe6percentofcapitalpaidin,andtransfersto surplusoccurinordertoequatesurplustocapitalpaidin.

45

Appendix 2: Constructing yield curves and coupons on purchased securities and valuation of the SOMA portfolio49
TheprojectionsforthecouponratesonTreasurysecuritiesdependonforecastsfortheyield curve.Weconstructazerocouponyieldcurveusingprojectionsforthefederalfundsrateand theforecastforthe10yearTreasuryyield,wheretheseindependentvariablesaretakenfrom theadjustedDecember2012BlueChipforecastforfutureinterestrates. Wespecifytherelationshipbetweenayieldattenoriandtheseratesusingaregression:

yit i 1i fft 2i (10 year )t it ,

whereyitisthezerocouponyieldformaturityiattimet,isaconstantterm,1iistheyield specificcoefficientonthefederalfundsrate,2iistheyieldspecificcoefficientonthe10year rate,anditisanerrorterm.Weevaluatethisspecificationonhistoricaldataatthe2,3,4,5, 10,15,20,and30yeartenors.Thehistoricaldataareyieldsconstructedfromanofftherun SvenssonNelsonSiegelzerocouponyieldcurve,theTreasuryyieldcurveusedinproduction workattheBoard.50ThesampleisdailydatafromJanuary3,1994toApril10,2010.Standard errorsarecalculatedusingarobustsandwichprocedure. TheestimatedcoefficientsandassociatedRsquaredstatisticsaredisplayedintheappendix tableA21.Ingeneral,theresultsareinlinewithintuitionandthesetworatescanexplain almostallthevariationintheotherrates.Inaddition,weperformedaseriesofrobustness checks.Specifically,longertermratestendedtoexhibitcointegrationwiththe10yearrate, butshortertermratesdidnot.Overall,theestimatedcoefficientsandresultingyieldcurves presentedherearebroadlysimilartothoseusingacointegratedorothertypeofspecification. Withtheseestimatesinhand,wethenconstructinitialyieldcurvesforeachpointintimein ourforecast,interpolatingvaluesfortenorsforwhichwedonotexplicitlyestimateamodel. WeusetheseforourprojectedcouponsonTreasurysecuritieswepurchaseovertheforecast period.
49 50

MuchofthemethodologydescribedinthissectionisattributabletoViktorsStebunovsandAriMorse. Fordetails,refertoGurkaynak,SackandWright(2007).

46

AnadditionalestimateisneededtoforecastthecouponrateonfutureMBSpurchases.Thisis donebyestimatingthestatisticalrelationshipbetweentheFannieMaeMBScurrentcoupon rate,the10yearTreasuryrate,andthe30yearfixedratemortgagerate.Weusequarterly averagesofdailydatafrom1984Q4to2011Q3togenerateourparameterestimates.Weuse anAR(3,1,0)modeltoaccountfortheautocorrelationintheerrortermsandthecointegration inthetwoseries.AsisevidentfromtableA22,changesinthe10yearrateand30yearfixed ratemortgageratearematchedalmostonetoonewiththoseintheMBScurrentcouponrate, andtheautocorrelationinthedifferencedseries,whilenotstrong,isstillpersistentenoughto berelevantintestsforautocorrelationoftheresiduals.

47

TableA21:Yieldcurveregressions Effectiverate Standard error 10yearrate Standard error 0.007 0.006 0.004 0.003 0.001 0.001 0.003 0.004 0.006 Constant Standard error Rsquared Tstat

Year

Coefficient

Tstat

Coefficient

Tstat

Coefficient

2 3 4 5 7 10 15 20 30 N Sample:

0.536*** 0.392*** 0.282*** 0.196*** 0.071*** 0.039*** 0.121*** 0.149*** 0.168*** 4067

0.003 155.438 0.003 131.062 0.002 116.573 0.002 107.059 0.001 87.829

0.746*** 0.877*** 0.945*** 0.980*** 1.003*** 1.000*** 0.995*** 1.013*** 1.083***

109.305 154.592 211.367 293.544 678.057 1420.984 397.277 269.745 196.249

0.018*** 0.018*** 0.015*** 0.012*** 0.006*** 0.002*** 0.008*** 0.010*** 0.005***

0 62.483 0 72.969 0 80.671 0 87.013 0 95.999 0 0 0 0 59.475 76.072 54.576 19.391

0.971 0.975 0.982 0.988 0.997 0.999 0.983 0.953 0.9

0 119.39 0.001 88.754 0.002 64.611 0.004 46.25

1/3/19944/10/2010

48

 TableA22:MBScouponforecastingregression

Dependentvariable:(FannieMae30yearcurrentcoupon) Std. Coefficient Error (10yearrate) 0.235 0.051 (30yrfixedratemortgagerate) 0.858 0.059 Constant 0.004 0.007 ARTerm L1 0.254 0.109 L2 0.07 0.111 L3 0.242 0.121 N=107 Sampleperiod:1984Q4to2011Q3

49

Figure 1 Federal Reserves Assets and Liabilities

3,000

2,500 Support for specific institutions (ML LLCs, Bear, AIG) 2,000 Other credit facilities (PDCF, AMLF, CPFF, TALF)

1,500

Assets
1,000

Central bank liquidity swaps

Agency debt and MBS holdings

Loans (includes term auction credit) Repurchase agreements

500
Treasury securities held outright

$ Billions

All other assets

Federal Reserve notes in circulation

500

Reverse RPs

1,000

Capital Other Liabilities>

Liabilities
1,500

U.S. Treasury accounts

Other Deposits >

Deposits of depository institutions

2,000

2,500

3,000 Jan 4, 2006

Jul 4, 2006

Jan 1, 2007

Jul 1, 2007 Dec 29, 2007 Jun 27, 2008 Dec 25, 2008 Jun 24, 2009 Dec 22, 2009 Jun 21, 2010 Dec 19, 2010 Jun 18, 2011 Dec 16, 2011 Jun 14, 2012 Dec 12, 2012 Wednesdays

Last updated December 26, 2012.

Source: H.4.1 Statistical Release

Figure 2 Federal Reserves Income and Expense

90

80

70

Income
60

Special liquidity facilities > 50

$ Billions

40 Central bank liquidity swaps > Loans (including term auction credit) > 30

Agency debt and MBS

20

Treasury securities

10

0 Reverse RPs

Foreign currency (gain/loss) Other expenses Interest paid on DI deposits > Transfers to surplus Dividends paid

10

Expense
20 2006 2007 2008 Annual 2009 2010 2011

Source: Annual Report of the Federal Reserve Board of Governors

Figure 3 - Federal Reserve Distributions to the U.S. Treasury $Billion

90 80 70 60 50 40 30 20 10
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012*

Figure 4 - SOMA, Capital + FR Notes, and Reserve Balances

$Billion 3000 2500

SOMA Capital+Notes Reserve Balances

2000 1500 1000 500 0

0
1990 1993 1996 1999 2002 2005 2008 2011

Source: Annual Report of the Federal Reserve Board of Governors; *Preliminary unaudited estimate, see http://www.federalreserve.gov/newsevents/press/other/20130110a.htm

Source: H.4.1 Statistical Release

Figure 5 - Weighted Average Maturity of SOMA

Months 140 120

Figure 6 - Weighted Average Coupon of SOMA

Percent 10 8 100 80 60 40 2 20 0 0
1980 1984 1988 1992 1996 2000 2004 2008 2012

6 4

1980

1984

1988

1992

1996

2000

2004

2008

2012

Note. Includes only nominal Treasury securities; Source: Federal Reserve Bank of New York

Note. Includes only nominal Treasury securities; Source: Federal Reserve Bank of New York

Figure 7 - Interest Income

$Billion 100

Figure 8 - Selected Treasury Receipts

$Billion 2000

Total Interest Income SOMA Interest Income

80 60

Fed Earnings Social Security Individual Income Taxes Corporate Income Taxes

1500

1000 40 500 20 0 1980 1985 1990 1995 2000 2005 2010 1996 1999 2002 2005 2008 2011
Source: Annual Report of the Federal Reserve Board of Governors Source: United States Treasury Bulletin

Figure 9 - Interest Rates*

Federal Funds Rate
percent Quarterly 7

Baseline Higher Rates

0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

10 year Treasury Rate

percent Quarterly 7

Baseline Higher Rates

5

1 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
* Baseline interest rate paths are the consensus December 2012 Blue Chip forecast, other interest rate paths are authors calculations

Figure 10 - Selected Assets Projections

SOMA Holdings
Billions of dollars Monthly 5000 Monthly

SOMA Treasury Holdings

Billions of dollars 4000

No Purchases in 2013 $500bn Purchases $1trn Purchases

4500 4000

No Purchases in 2013 $500bn Purchases $1trn Purchases

3500

3000 3500 3000 2500 2000 1500 1000 1000 500 500 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 0 2500

2000

1500

SOMA Agency MBS Holdings

Billions of dollars Monthly 2000

SOMA Agency Debt Holdings

Billions of dollars Monthly 600

No Purchases in 2013 $500bn Purchases $1trn Purchases

1800 1600 1400 1200

No Purchases in 2013 $500bn Purchases $1trn Purchases

500

400

300 1000 800 600 100 400 200 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 200

Source: Authors Projections

Figure 11 - Selected Liabilities Projections

FR Notes
Billions of dollars Monthly 2200 Monthly

Treasury General Account

Billions of dollars 240

No Purchases in 2013 $500bn Purchases $1trn Purchases

2000 1800 1600 1400

No Purchases in 2013 $500bn Purchases $1trn Purchases

220 200 180 160 140

1200 120 1000 800 600 400 200 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 100 80 60 40 20 0

Capital Paid In
Billions of dollars Monthly 220

Reserve Balances
Billions of dollars Monthly 3500

No Purchases in 2013 $500bn Purchases $1trn Purchases

200 180 160 140 120 100

No Purchases in 2013 $500bn Purchases $1trn Purchases

3000

2500

2000

1500 80 60 40 20 0 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 500 1000

Source: Authors Projections

Figure 12 - Income Projections

SOMA Interest Income
Billions of dollars Annual 120 100 80 60 40 Annual

Interest Expense
Billions of dollars 120

No Purchases in 2013 $500bn Purchases $1trn Purchases

100 80 60 40 20 0

No Purchases in 2013 $500bn Purchases $1trn Purchases

20 0

2011

2015

2019

2023

2011

2015

2019

2023

Realized Capital Losses

Billions of dollars Annual 120

Remittances to Treasury
Billions of dollars Annual 120 100 80 60 40 20 0 -20 60 40 20 0 2011 2015 2019 2023

No Purchases in 2013 $500bn Purchases $1trn Purchases

No Purchases in 2013 $500bn Purchases $1trn Purchases

100 80

2011

2015

2019

2023

Deferred Asset
Billions of dollars End of year 160 140 120 100 80 60 40 20 0

Unrealized Gains/Losses
Billions of dollars End of year 325

No Purchases in 2013 $500bn Purchases $1trn Purchases

No Purchases in 2013 $500bn Purchases $1trn Purchases

250 175 100 25 -50 -125 -200 -275 -350

2011

2015

2019

2023

2011

2015

2019

2023

Source: Authors Projections

Figure 13 - Selected Balance Sheet Items with Higher Interest Rates

SOMA Holdings
Billions of dollars Monthly 5000 Monthly

SOMA Treasury Holdings

Billions of dollars 4000

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

4500 4000

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

3500

3000 3500 3000 2500 2000 1500 1000 1000 500 500 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 0 2500

2000

1500

SOMA Agency MBS Holdings

Billions of dollars Monthly 2000

Reserve Balances
Billions of dollars Monthly 3500

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

1800 1600 1400 1200

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

3000

2500

2000 1000 800 600 1000 400 200 0 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 500 1500

Source: Authors Projections

Figure 14 - Income Projections with Higher Interest Rates

SOMA Interest Income
Billions of dollars Annual 120 100 80 60 40 Annual

Interest Expense
Billions of dollars 120

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

100 80 60 40 20 0

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

20 0

2011

2015

2019

2023

2011

2015

2019

2023

Realized Capital Losses

Billions of dollars Annual 120

Remittances to Treasury
Billions of dollars Annual 120 100 80 60 40 20 0 -20 60 40 20 0 2011 2015 2019 2023

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

100 80

2011

2015

2019

2023

Deferred Asset
Billions of dollars End of year
No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

Unrealized Gains/Losses
Billions of dollars 160 140 120 100 80 60 40 20 0 End of year 325 250 175 100 25 -50 -125 -200 -275 -350 2011 2015 2019 2023

No Purchases in 2013 Higher IR No Purchases Higher IR $500bn Purchases Higher IR $1trn Purchases

2011

2015

2019

2023

Source: Authors Projections

Figure 15 - Interest Rates*

Federal Funds Rate
percent Quarterly 7

Baseline Lower Rates

0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

10 year Treasury Rate

percent Quarterly 7

Baseline Lower Rates

5

1 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
* Baseline interest rate paths are the consensus December 2012 Blue Chip forecast, other interest rate paths are authors calculations

Figure 16 - Selected Balance Sheet Items with Lower Interest Rates

SOMA Holdings
Billions of dollars Monthly 5000 Monthly

SOMA Treasury Holdings

Billions of dollars 4000

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

4500 4000

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

3500

3000 3500 3000 2500 2000 1500 1000 1000 500 500 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 0 2500

2000

1500

SOMA Agency MBS Holdings

Billions of dollars Monthly 2000

Reserve Balances
Billions of dollars Monthly 3500

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

1800 1600 1400 1200

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

3000

2500

2000 1000 800 600 1000 400 200 0 0 2007 2011 2015 2019 2023 2007 2011 2015 2019 2023 500 1500

Source: Authors Projections

Figure 17 - Income Projections with Lower Interest Rates

SOMA Interest Income
Billions of dollars Annual 120 100 80 60 40 Annual

Interest Expense
Billions of dollars 120

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

100 80 60 40 20 0

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

20 0

2011

2015

2019

2023

2011

2015

2019

2023

Realized Capital Losses

Billions of dollars Annual 120

Remittances to Treasury
Billions of dollars Annual 120 100 80 60 40 20 0 -20 60 40 20 0 2011 2015 2019 2023

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

100 80

2011

2015

2019

2023

Deferred Asset
Billions of dollars End of year
No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

Unrealized Gains/Losses
Billions of dollars 160 140 120 100 80 60 40 20 0 End of year 325 250 175 100 25 -50 -125 -200 -275 -350 2011 2015 2019 2023

No Purchases in 2013 Lower IR No Purchases Lower IR $500bn Purchases Lower IR $1trn Purchases

2011

2015

2019

2023

Source: Authors Projections