The year was 2007. The U.S. Federal Reserve's balance sheet boasted of $869 billion in total assets. The following year, as the global financial crisis took its toll on the U.S. economy, the Fed cut interest rates close to zero percent and started buying bonds in order to boost liquidity and spur growth.
Six years, multiple rate cuts, and three rounds of quantitative easing programs later, the Fed's balance sheet now stands at little over $3 trillion - a significant amount of money, to say the least. This represents the amount that the U.S. central bank has invested in the economy in hopes that it will eventually perform better.
Analysts over at Morgan Stanley Capital International Incorporated, or MSCI Inc., decided to see whether the Fed's investment will be able to pay off in the future. Using the same stress test scenarios that the Fed applied to 19 of the largest banks in the country, MSCI estimated the potential results when the economy performs well or ends up falling back into recession.
In the best case scenario wherein the U.S. economy is able to keep growing, it was estimated that losses would amount to only $216 billion. In the worst case scenario where the economy slumps back in recession and interest rates decline, the Fed is at the risk of losing $547 billion in the next three years. Either way, the Fed stands to lose a LOT of money.
Don't sweat it though - Fed officials knew from the get-go that these losses would be a real possibility.
Remember, the Fed is made up of some of the smartest financial gurus in the entire world. The potential for the central bank to incur huge losses hasn't escaped their minds, as was revealed by the latest FOMC meeting minutes. In their last meeting, more than a few FOMC members expressed concern about the state of the Fed's asset purchases.
The good news though is that the Fed cannot go bankrupt and that it can still continue its operations even if it's got big fat red marks on its books.
The problem though, is that it will put the central bank through a ton of public scrutiny.
First, some Fed members like James Bullard, are pushing for allowing the Fed to hold back some of its Treasury remittances in order to give the central bank some allowance against losses. This however, probably won't sit well with members of Congress.
What also won't go down well is that with the large portion of assets on its portfolio, money that would otherwise be used to pay remittances to the Treasury would effectively be paid to large financial institutions via interest paid on reserves. Yes, the very same institutions that need assistance will actually be making money off of the Fed!
This could damage the Fed's reputation, as the public may not understand exactly what the Fed is trying to accomplish.
Nevertheless, the Fed will most likely stick with its current direction and maintain its bond purchasing ways. The Fed's main purpose is to stabilize the economy and right now, it might not have any other choice but to hold its bonds, even if it means taking a hit sometime down the road.