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The Fed is gearing itself up for a classic I Love Lucy moment. When the economy recovers, interest rates rise and Congress figures out that the Federal Reserve System is the biggest financial black hole in the history of mankind, there's going to be a lot of explaining to do.

Bernanke hasn't told anyone quantitative easing's big secret; it isn't free. There's a cost to the Fed's policy and the bill will be past due when the economy recovers and interest rates rise. The tab may be big enough to blow the Federal budget and plunge Washington into a new fiscal and political crisis. And, there won't be many policy choices. The Fed cannot be allowed to fail. Like it or not, it carries the full faith and credit of the United States of America.

The problem will arise when growth is strong enough for interest rates to increase. At that time, the Fed is going to lose money, and since the Fed has built up a $3 trillion balance sheet, likely a lot.

What the Fed has been downplaying is the paradox of quantitative easing. When the economy is underperforming and demand is insufficient to create sustained inflationary pressure, the Fed produces a profit, which it distributes to the Treasury and is used to lower the deficit. That is what's happening now. The Fed is subsidizing the rest of Washington.

The Fed makes money because it borrows in short-term money markets at very low cost and uses its borrowed funds to buy trillions of dollars of long-term fixed rate bonds at higher yields. The Fed pockets the difference between the cost of its borrowing and the yield on its bonds. Currently, the Fed is making about $85 billion a year from its "borrow short and invest long strategy." If the Fed balance sheet grows even bigger, it could make even more.

However, there is no free lunch in banking and the reason that the Fed is making money is because it is taking on a lot of interest rate risk. In fact, it is taking on more interest rate risk than any public or private institution since forever.

The interest rate risk problem kicks in when the economy recovers and interest rates rise, which is sure to happen sooner or later. When the inevitable occurs, the cost of Fed borrowings will go up but its bond yields will remain static. At first the Fed will earn less and less and then as rates keep going up it will start to operate at a loss. Even worse, the market value of its assets will decline causing mark to market losses.

That's the paradox of quantitative easing - if quantitative easing works and demand increases, the Fed is destined to lose a lot of money and probably bust the Federal budget. The Fed is only safe from losses if quantitative easing fails and the U.S. remains in perpetual economic stagnation.

How big a tab has the Fed run up? Between operating losses and mark to market losses the bill may be in the hundreds of billions of dollars and possibly over a trillion dollars. An increase of 2.00% in the Federal Funds rate will likely push the Fed into the red and a rapid increase of 4.00% in the Federal Funds rate will create horrific losses that will shock the consciousness of even the most ardent Fed fans.

Unfortunately, because of the size of the Fed's balance sheet what seemed like a manageable problem when quantitative easing started is now a ticking time bomb.

If the Fed were a private institution, or had a smaller balance sheet, it could buy hedges and swaps as protection from rising interest rates. However, the Fed isn't a private institution and its balance sheet is much too large to hedge. Just imagine the Fed trying to collect on a few trillion dollars of interest rate swaps and in the process killing off too-big-to-fail banks.

Also, there is no realistic way for the Fed to sell off its portfolio of bonds and mortgages to avoid loss. While the Fed can sell some of its bonds, as a practical matter its $3 trillion balance sheet cannot be liquidated. It's just too large to liquidate.

It belatedly occurred to members of the Fed's policy making apparatus in their December meeting that an infinite increase in the size of the Fed's balance sheet may not have been their best policy idea. According to Fed minutes, policy makers are divided on when to stop growing the balance sheet. Media sources have reported that some Fed policy makers are wondering how they will exit quantitative easing without taking losses.

Bernanke needs to get ahead of this problem before his cherished institution becomes a Congressional ward, and the process begins with communication. Unfortunately, the economic education process isn't quick, it isn't easy and it may fail. Even worse, it isn't in the DNA of Fed technocrats to provide easy to understand information about what it likely to happen and how big the quantitative easing bill maybe.

Perhaps Bernanke unintentionally took the path of least resistance by neglecting to mention that there is a cost to Fed monetary policy. Or, maybe Bernanke is more of an economist than a politician and communications aren't his strong suit. Either way, Bernanke has set up the next Fed Chairman for the political fight of a lifetime.

Source: The Fed's Big Secret - Quantitative Easing Isn't Free