By Terry Coxon in The Casey Report:

There are two ways for a commercial bank to get into trouble. One is to take in money from depositors and put it into loans that don’t get repaid, or into investments that lose value. The second is to take in money through checking accounts and short-term CDs and put it into fixed-rate, long-term loans. Even if the long-term loans get repaid, the cost of holding on to the short-term deposits can crush a bank if interest rates rise enough. The bank must pay more and more to keep the deposits from leaving, even though the earnings on the bank’s long-term loans are frozen.

The Federal Reserve has embraced both dangers. Most of what it has bought is high-risk paper (the mortgage-backed securities), which means it faces the risk of loss from defaults. And most of its investments, including the Treasury securities, are fixed-rate, long-term paper, which means that, even without defaults, the income they produce is frozen.

Unlike a commercial bank, the Fed has financed its investment purchases with money it created. But given that the Fed must pay interest on the new money to keep it sequestered, its position is no more comfortable than that of a commercial bank that must pay interest to persuade ordinary depositors not to take their money elsewhere. So when interest rates start rising, as eventually they will, the Fed’s interest expense will rise. If interest rates rise enough -- as they may -- the Fed will be paying more in interest than it is earning on its investments.

How would it make up for such a shortfall? It would print the money, of course, but that would add to the volume of reserves on which it must pay interest. I’m sure you can see where that would lead.

It’s a remarkable accomplishment, one that only a government institution could hope to achieve. Even though the Federal Reserve has the power to print money, it has found a way to operate at a loss. The loss, no matter how large it might become, wouldn’t lead to default, because the Fed can always print again. But it could lead to an inflationary catastrophe.

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