Federal Reserve Couldn’t Pass A Stress Test, Says Former Fed Economist

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Federal Reserve Couldn’t Pass A Stress Test, Says Former Fed Economist
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As the most systemically important financial institution in the country, it was only a matter of time before someone asked the question: what would happen if we applied the same standards to the Federal Reserve that the Fed has been applying to major banks like Citigroup Inc (NYSE:C) and Bank of America Corp (NYSE:BAC) during its annual stress test?

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Federal Reserve would flunk its own stress test: Hein

“If the Federal Reserve were a commercial bank it would probably flunk its own stress tests,” writes Texas Tech University finance professor and former senior economist at the Federal Reserve Bank of St. Louis Scott E. Hein for American Banker.

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Hein argues that the best way to think about QE is that the Fed is buying reserves (in the sense that it pays 0.25% interest on them) to fund its long-term security purchases, which return about 3%. Looked at this way, QE looks similar to the 1980s savings and loan crisis which was caused by maturity intermediation tactics that turned sour interest rates started to rise. He argues that the Fed is similarly positioned to lose money when short term interest rates start to rise, and that if it were a commercial bank regulators would be taking it to task for having such an irresponsible policy.

“The Fed today is exposing itself to similar financial losses should interest rates rise,” he writes. “An end to the ill-advised quantitative easing program can’t come soon enough.”

Fed doesn’t play the same role as commercial banks

Of course, the Federal Reserve isn’t a commercial bank. Being in charge of the nation’s money supply, it isn’t subject to the same stresses as a commercial bank, and as the lender of last resort (to the world, really) it doesn’t play the same role. Aside from trying to stabilize the financial sector, it’s supposed to keep inflation in line and unemployment low with really just a handful of policy tools. It’s obvious that a commercial bank would have gone bust long ago trying to pull off something like QE, but that’s why the Fed exists.

It doesn’t seem like the markets have come to terms with what it will mean to watch the Federal Reserve drain years of excess liquidity, and there’s an argument to be made that the price of the short term fix will be years of muted growth, so there’s plenty of reason to want QE ended sooner rather than later. But saying that the Fed couldn’t pass its own stress tests seems more like an apples-to-oranges comparison than a biting critique of QE.

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Michael has a Bachelor's Degree in mathematics and physics from Boston University and Master's Degree in physics from University of California, San Diego. He has worked as an editor and writer for several magazines. Prior to his career in journalism, Michael Worked in the Peace Corps teaching math and science in South Africa.
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