Monetary Policy as a Carry Trade
Keynote Speech by Marvin Goodfriend
Quantitative monetary policy at the zero interest bound should be understood as a “bond market carry trade.” Net interest earnings on the front
end of the monetary carry trade should be retained—to guard against thecentral bank having to create reserves (or borrow) to pay interest on reserves or managed liabilities on the back end, and to show that interest
expenses are paid for in large part by earnings from the front end. In the
United States, the Federal Reserve balance sheet reflects the front end of acarry trade in that by the end of 2014, about $3 trillion of reserves paying
0.25% will finance (carry) a like quantity of security holdings averaging
10 years or more in maturity earning 2.5%. The Fed has long asserted
independent authority to retain net interest income thought necessary as
surplus capital against prospective exposures on its balance sheet. The
Fed recognizes that the retention of net interest earnings to build up surplus capital incurs no resource cost for the Treasury or taxpayers. Yet,the Fed has chosen not to build up surplus capital against the carry trade
exposure and risk on its balance sheet, jeopardizing the operational credibility of monetary policy for price stability.
Keywords: Bond market carry trade; Federal Reserve surplus capital;
Federal Reserve Treasury remittances; Inflation objective; Interest on reserves; Monetary policy at the zero interest bound;Term premium
JEL Classification: E31, E43, E52, E58, E63

Friends of Allan Meltzer Professor of Economics, Tepper School of Business, Carnegie Mellon
University (E-mail: marvingd@andrew.cmu.edu).....................................................................................................................
The author would like to thank Al Broaddus, Huberto Ennis, Hiroshi Fujiki, Ichiro Fukunaga,
Robert Hetzel, Todd Keister, Elizabeth Klee, Pierre Liang, Allan Meltzer, Charles Plosser,
Chester Spatt, and Charles Steindel for discussions and correspondence that greatly improved
the paper. The paper benefitted from an initial presentation at the 2014 BOJ-IMES Conference“Monetary Policy in a Post-Financial Crisis Era” at the Bank of Japan, and from subsequent
presentations at the Federal Reserve Bank of Richmond, the 2014 International Business Cycle
Conference of the Kiel Institute for the World Economy in Berlin, and the 2014 Swiss National
Bank (SNB) Research Conference “Exit Strategies.” Formal discussions of the paper at the SNB
conference by David Archer and Thomas Moser were especially appreciated. Research for thepaper was undertaken initially for a presentation, “The 1951 Accord: Its Historic Significanceand Relevance for Current Policy,” at the 10th Philadelphia Fed Policy Forum in December 2013.
The views expressed in this paper are those of the author and do not necessarily reflect the oﬃcial
views of the Bank of Japan.

MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION

29

I. Introduction
Ordinarily, an interest rate policy benchmark such as the Taylor Rule works well tosteer monetary policy. A policy rule acts against the inflationary temptation to slide
into discretionary stimulus (whose benefits come early and costs later) and to guidemonetary stimulus when needed to counteract deflation. Often overlooked or taken
for granted is that an interest rate rule works well because it is “operationally credible,”
meaning: i) the central banker has the operational power(s) to manage short-term interest rates according to the rule, ii) the central banker is demonstrably willing to employ
interest rate policy according to the benchmark rule, on occasion more aggressively ifneed be to enforce its credibility, and iii) the public and the monetary policy oversightcommittees in the legislature accept (i) and (ii).
The credible interest rate rule for monetary policy geared to low inflation was along time coming. For instance, in the United States the Fed won independence for its
interest rate instrument from the Treasury in the 1951 Accord; later, the Fed learned
from the Great Inflation that rising inflation produced rising unemployment; the 1980s
Volcker Fed showed that aggressive interest rate policy could bring inflation down at
considerable, but temporary, cost in unemployment: the 1990s Greenspan Fed demonstrated that well-timed interest rate policy actions could sustain price stability without
recession; and the public came to regard interest rate policy actions as acceptable andnecessary to sustain low inflation and the lowest unemployment that monetary policy
alone could deliver.
By the end of 2014, it will be six years that interest rate policy in the United Stateshas been immobilized at the zero bound. Only one of the abovementioned understandings that produced operationally credible monetary policy from the earlier period
carried over intact at the zero bound—the case for price stability. The Federal Open
Market Committee reinforced that understanding by formally adopting a 2% inflation
objective in January 2012. The remaining operational understandings regarding monetary policy no longer applied.
Section II explains that quantitative monetary policy credibility against deflation at
the zero interest bound necessitates a willingness to create bank reserves via the acquisition of long-term securities on an unprecedented scale far beyond limits ordinarily
thought prudent. Section III explains that interest on reserves secures credibility for
aggressive enlargement of the balance sheet against deflation by enabling the central
bank to raise interest rates against inflation, if need be, flexibly and precisely without
first shrinking its balance sheet.
Section IV observes that quantitative monetary policy at the zero bound should
be understood as a “bond market carry trade,” involving as it does the acquisitionof higher-interest long-term bonds with funds acquired by issuance of lower-interest
short-term liabilities. In the United States, the Federal Reserve balance sheet reflects
a carry trade in that by the end of 2014, about $3 trillion of reserves paying 0.25%
will finance (carry) a like quantity of security holdings averaging 10 years or more inmaturity earning an average 2.5%. When interest rate policy exits the zero bound, theFed will have to pay interest on reserves in line with market interest rates to carry $3
trillion of securities on its balance sheet.

30 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014

Monetary Policy as a Carry Trade

The “bond market carry trade” framework is useful because it identifies financial
and fiscal issues that an independent central bank should address to attain operational
credibility for quantitative monetary policy at the zero bound. In particular, the central
bank should retain net interest income earned on the front end of its carry trade (wheninterest paid on reserves is at or near zero) against expected interest costs and riskon the back end of its carry trade (when interest paid on reserves must follow market
interest rates higher). Retained earnings guard against the central bank having to create
reserves (or borrow) to pay interest on reserves on the back end its carry trade. And
retained earnings mitigate criticism of the cost of interest on reserves by making clearthat interest on reserves is paid for in large part by earnings from the front end of thecarry trade.1
Section V documents that the Federal Reserve has long asserted independent
authority to retain net interest earnings thought necessary as surplus capital againstprospective exposures and risk on its balance sheet. Moreover, the Fed recognizes
that withholding net interest earnings to build up surplus capital incurs no resource
cost for the Treasury or taxpayers. Yet the Fed has chosen not to build surplus capital
above its modest longstanding level while remitting around $80 billion per year to
the Treasury since 2010 on the front end of its monetary carry trade. The Fed should
suspend transfers to the Treasury and build up surplus capital against the enormous,unprecedented carry trade exposure and risk on its balance sheet.
Section VI acknowledges that the retention of net interest earnings by the Fed tobuild up surplus capital creates a problem for the Treasury under the federal debt ceiling. However, legislation signed into law in February 2014 suspended the debt ceilingthrough March 2015. The Fed could stop transferring net interest income to the Treasury while the debt ceiling is suspended, and work with the fiscal authorities to facilitate
the buildup of its surplus capital thereafter, perhaps by obtaining an exemption for its
holdings of Treasuries from the debt ceiling, at least until the Fed can normalize its
balance sheet.

II. Monetary Policy at the Zero Interest Bound
A central bank drives short-term nominal interest rates to zero by satiating banks withreserves. Transactions services provided by bank reserves, deposits, and currency arethen no longer scarce, and the narrow liquidity channel of monetary policy transmission is exhausted. At that point, ordinary interest rate policy is severely attenuated,and “forward guidance” must be relied upon to deliver additional interest rate policy
stimulus.
Broad liquidity is not satiated at the zero interest bound, however, and provides
the means for quantitative monetary policy to deliver additional monetary stimulus.2
Broad liquidity services are provided by assets according to how easily they can be................................
1. Archer and Moser-Boehm (2013), Carpenter et al. (2013), Christensen, Lopez, and Rudebusch (2014), Del
Negro and Sims (2014), Hall and Reis (2013), and IMF (2013) assess empirically and theoretically questionsof central bank insolvency.
2. This section draws from Goodfriend (2000).

31

turned into cash if need be, either by their sale or by serving as collateral for externalfinancing. Bank reserves, transactions deposits, and currency provide broad liquidity
services at the zero interest bound; and time deposits, money market instruments, andTreasury bills are the most broadly liquid non-monetary assets.
Expansive monetary policy at the zero interest bound works much like ordinary
monetary policy—through a portfolio rebalancing channel and a credit channel muchintertwined. The common total, risk-adjusted expected return on any security or asset
is composed of a pecuniary return plus an implicit broad liquidity service yield. The
more liquid an asset, the higher is its implicit liquidity service yield and the lower is its
pecuniary yield. An injection of broadly liquid assets by the central bank drives down
implicit broad liquidity service yields on all assets and gives households and firms an
incentive to trade broadly liquid assets for less liquid assets with a higher pecuniary
rate of return. Portfolio rebalancing drives the pecuniary yield on less liquid assets
down and their prices up.
Lower long-term interest rates and higher asset prices raise desired consumption
relative to current income. And higher asset prices relative to their cost of production
stimulate investment. Strengthened consumption and investment stimulate employment. Higher utilization rates and profits raise asset prices further.
Because asset prices are higher, collateral values are higher, net worth is higher,
and bank capital is higher. Higher net worth and collateral valuations to back loansbring down the external finance premium. Credit spreads narrow. Bank lending andspending are stimulated as the cost of borrowing against future income prospects falls.
The credit-channel stimulus occurs alongside the portfolio rebalancing channel.
The central bank’s primary policy problem upon hitting the zero interest bound isto establish from scratch and on short notice operational credibility for quantitative
monetary policy against deflation. To do so, the central bank must be prepared (andconvince markets that it is prepared) to increase the stock of broadly liquid assets immediately and aggressively as needed to act against deflation. In addition, the central
bank must extend the maturity of its open market purchases from short-term securities
to less liquid long-term securities so that each dollar of bank reserves created to buy
securities delivers a large net increase in broadly liquid assets.3 And the central bankmust recognize that to exert significant monetary stimulus via broad liquidity, quantitative monetary policy must act on a very large scale given the large stock of broadly
liquid assets in the economy.
In the United States, the stock of broadly liquid assets was around $15 trillion in2008.4 The logic above suggests that the Federal Reserve’s extraordinarily aggressive
quantitative monetary policy was called for in the wake of the Great Recession. The
Fed’s aggressive monetary stimulus likely played a critically important, if not the decisive role in averting deflation that might have occurred otherwise.

................................
3. A given net broad liquidity stimulus delivered via the acquisition of short-term securities alone would require much more reserve creation, which would take time and involve potential complications regarding theimmobilization of reserves discussed in Section IV.C.
4. Goodfriend (2011a, p. 120).

32 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014

Monetary Policy as a Carry Trade

III. The Role of Interest on Reserves
The Fed began to pay interest on reserves in October 2008 after asking Congress to expedite authorization granted in the Financial Services Regulatory Relief Act of 2006.5
Interest on reserves would create a floor below which banks would not lend to eachother in the federal funds market.6 As initially envisioned, interest on reserves would
enable the Fed to create bank reserves on a massive scale to re-intermediate distressedbanking and money market borrowers without lowering the federal funds rate target.7
As it happened, the Fed cut interest on reserves to 1/4% in December 2008 to fightthe Great Recession, and interest rate policy has been immobilized at zero since then.
Nevertheless, expedited authority to pay interest on reserves was then crucial for establishing operational credibility for monetary policy against both inflation and deflation. 8
To build operational credibility quickly against deflation, the Fed had to demonstrate a willingness to follow its initial open market purchases of long-term securities
with trillions more, if need be. In other words, the Fed had to show itself (and the public
had to believe the Fed to be) undeterred from overshooting its balance sheet expansion
against deflation for fear of triggering inflation. The October 2008 emergency acquisition of the power to pay interest on reserves enabled the Fed to do just that, becauseinterest on reserves gave the Fed the operational capability to reverse field and raisemarket interest rates quickly and aggressively against inflation without first shrinking
its balance sheet. Without authorization to pay interest on reserves, the Fed would have
had to sell securities to drain nearly all the reserves created against deflation in order
to lift the federal funds rate much above zero, which would have been diﬃcult, if not
impossible to do in a timely and orderly manner.9

IV. Monetary Policy as a Carry Trade
Operationally credible monetary policy at the zero bound should be understood as a“bond market carry trade,” involving as it does the acquisition of higher-interest longterm bonds with funds acquired by issuance of lower-interest short-term (bank reserve)liabilities. The Federal Reserve balance sheet reflects a carry trade in that by the endof 2014 about $3 trillion of reserves paying 0.25% will finance (carry) a like quantityof security holdings averaging 10 years or more in maturity earning an average 2.5%.10
When interest rate policy exits the zero bound, the Fed will have to pay interest on
reserves in line with market interest rates to carry $3 trillion of securities on its balance
sheet.
................................
5. Authority for the Fed to pay interest on reserves was initially legislated to begin in 2011.
6. The federal funds rate has fallen below interest on reserves because some large non-depository lenders in thefederal funds market are ineligible to earn interest on their balances at the Fed. See Goodfriend (2011b, pp. 7,
8, 11), and Federal Reserve Bank of New York (2014, pp. 20–21).
7. Goodfriend (2002).
8. Chairman Bernanke in his written testimony for the July 2009 Monetary Policy Report to Congress(p. 3)
emphasized that the authority to pay interest on reserves would be the most important tool enabling the Fed
to raise interest rates without shrinking its balance sheet.
9. The utilization of reserve requirements alone to absorb reserves on such a large scale would have been problematic. See Section IV.C.
10. See Board of Governors of the Federal Reserve System (2008, 2014).

33

The Fed created $1 trillion of reserves to re-intermediate short-term credit markets in the fall and winter of 2008–09 and will have created about $2 trillion more inthree waves of quantitative easing (QE) by the end of 2014.11 In all, Fed assets will
have expanded to around $4.5 trillion, from $1 trillion in September 2008 when Fed
assets were financed almost entirely by currency and only about $25 billion of bankreserves.12 During this period, the Fed also more than doubled the average maturity of
its portfolio of securities. From December 2007 to December 2012 the average maturity of Treasury securities in the Fed portfolio increased from around 5 years to over 10
years.13 And to April 2014 the Fed acquired $1.6 trillion of mortgage backed securities
with average maturity over 10 years.14
The “bond market carry trade” framework is useful because it identifies financial
and fiscal issues that an independent central bank should address to secure operational
credibility for quantitative monetary policy against inflation and deflation at the zerointerest bound and in the exit from the zero bound. Section IV addresses four aspectsof the monetary carry trade in turn: i) why run a carry trade, ii) cash flows, risk, andexpected returns, iii) immobilization of bank reserves, and iv) the negative cash flow
problem.
A. Why Run a Carry Trade?
The central bank could unwind its carry trade before short-term interest rates are expected to exit the zero bound. Open market sales then could drain reserves without
realizing capital losses on sales of long-term securities. Preemptive shrinking of thecentral bank balance sheet, however, has operational problems. Selling trillions oflong-term securities takes time, and might inadvertently signal a premature elevationof future short-term interest rates and induce an unwelcome elevation of long-term
rates. A “catch-22” problem would deter the central bank from attempting to unwind
its carry trade well before interest rates need to rise. At that point, however, the central
bank could not avoid capital losses on the sale of its long bonds.
Such considerations suggest that the best that can be hoped for is to unwind thecentral bank balance sheet over time according to a gradual pre-announced timetableor rule.15 The rule for normalizing the central bank’s balance sheet could be announced
after interest rate policy has exited the zero bound. The presumption should be that thecentral bank must be prepared to raise market interest rates against inflation, if need be,
by raising interest paid on reserves well before unwinding its carry trade.16 It is worth
noting that the quantitative monetary stimulus remaining in place on the back end of
the carry trade potentially necessitates higher short-term interest rates than otherwise
to deliver a given degree of monetary restraint against inflation.
................................
11. The first rounds of QE known as QE1 began in November 2008 and March 2009, QE2 began in November
2010, and QE3 began in September 2012.
12. Currency outstanding grew by around $500 billion during this period. See footnote 33.
13. Greenlaw et al. (2013, p. 70).
14. Federal Reserve Bank of New York (2014, pp. 4–7).
15. The rule could allow long bonds to run oﬀ at maturity and manage the shrinkage of the balance sheet more
precisely via operations in shorter-term securities.
16. International Monetary Fund (2013, p. 27).

34 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014

Monetary Policy as a Carry Trade

B. Cash Flows, Risk, and Expected Returns
A central bank that runs a monetary carry trade can expect unconditionally the following sequence of returns. Initially, the central bank earns the favorable spread between
long-term securities on its balance sheet and near-zero interest on reserves. When thetime is judged to be appropriate, the central bank revives interest rate policy by paying
higher interest on bank reserves to support higher short-term money market interest
rates. As the central bank carries the long bonds on its balance sheet, unconditionallyit can expect to give back (as interest on reserves) all net interest earnings accumulated
previously on the carry trade up to those reflecting the return to risk-bearing and forgone liquidity associated with the term premium on long bonds.17 If the central bankacquired its long bonds at prices which discounted future short-term interest rates accurately, and if the central bank plans to hold the bonds to maturity or nearly so, thenif its carry trade has little eﬀect on market prices and returns, the unconditional expected return on the monetary carry trade would just be the market-determined term
premium.18
Monetary carry trade risk arises primarily from possible errors forecasting future
short-term interest rates.19 For instance, the carry trade would take unexpected losses
if future short rates rise sooner than expected, or if short rates rise higher than expectedperhaps to fight an inflation scare, or if short rates settle higher than expected. Losses
could be especially large if the central bank allows rising inflation to take expected
inflation and the inflation premium in nominal interest rates higher as well.
Quantitative monetary policy undertaken aggressively to act against deflation
would tend to reduce expected returns on the monetary carry trade for two reasons.
Quantitative policy potentially depresses the term premium on long bonds acquired by
the central bank. And quantitative stimulus remaining on the central bank’s balance
sheet potentially necessitates higher short-term interest rates against inflation thanotherwise.
C. Immobilization of Bank Reserves
When the time comes to exit the zero interest bound, the large volume of bank reserves
created by the central bank would continue to press the rate at which banks lend toeach other down to the interest-on-reserves floor. In so doing, the large volume of bankreserves would continue to be immobilized as it was at the zero interest bound because
the zero opportunity cost of holding bank reserves would be perpetuated even as thecentral bank raises interest rates.
Recent experience has shown that depositories are willing to hold large quantities
of reserves at zero opportunity cost. For instance, as of April 2014 commercial banks................................
17. Gurkaynak and Wright (2012) discuss the macro-econometrics of the term premium. On p. 349, they report
estimates of the 10-year term premium in the United States from 1971 to 2009 from Christensen, Diebold,
and Rudebusch (2007). The estimated term premium is as high as 5% in the early 1980s and falls gradually
to range between 2% and 0% since 2000.
18. Empirical evidence indicates that the expectations hypothesis of the term structure of interest rates works
reasonably well unconditionally at long horizons. Cochrane (1999, pp. 46–48).
19. Risk also arises from errors forecasting the term premium. The analysis in the paper presumes implicitly thatthe central bank purchases default-free securities only.

35

in the United States held around 25% reserves against deposits.20 Nevertheless, a central bank running a monetary carry trade should prepare other means of immobilizingbank reserves in case aggregate reserves come to exceed the volume that depositories
are willing to hold. Excess reserves could become highly inflationary in that case, necessitating sharply higher short-term interest rates and the potentially disruptive, rapid
draining of reserves via the sale of securities from the central bank portfolio. A central bank can immobilize reserves in two additional ways: by borrowing reserves via
managed liabilities and by imposing reserve requirements on depository institutions.
Managed liabilities could be issued flexibly and in quantity to help absorb andimmobilize bank reserves on short notice, if need be. For instance, the Fed has begun
to oﬀer term deposits and reverse repurchase agreements to borrow reserves from both
depositories and a wide variety of money market counterparties.21 Interest that the Fed
pays on term deposits and reverse repurchase agreements should be expected to diﬀer
relatively little from interest on reserves.22 So managed liabilities would not changemuch the interest cost of the Fed’s monetary carry trade. Fed managed liabilities would
be subject to rollover risk in times of financial turmoil if cash came to be more highly
valued than safe short-term loans to the Fed. So the Fed should use managed liabilities
relatively sparingly to immobilize reserves. Mainly, managed liabilities will be usefulfor fine-tuning money market interest rate spreads relative to interest paid on bankreserves in the implementation of interest rate policy.23
Reserve requirements could be utilized to help absorb and immobilize bank reserves. However, reserve requirements would be costly to enforce and administer ona large scale, especially if little or no interest were paid on required reserves. The
reserve requirement tax would hurt bank profits, raise the cost of depository financial
intermediation, and encourage tax avoidance behavior by depositories of the sort thathas been a problem in the past. So if reserve requirements were employed extensively
to immobilize reserves, required reserves would have to pay interest near the interbank
interest rate, in which case reserve requirements would save little on the interest costof the monetary carry trade.
D. The Negative Cash Flow Problem
It is not diﬃcult to imagine circumstances in which a deeply negative net interest margin on the back end of a monetary carry trade could produce a negative cash flow
problem for a central bank. For instance, a central bank acting against persistent deflation could acquire trillions of dollars of long bonds at very low interest which proves
insuﬃcient to cover interest-on-reserves expenses on the back end of the carry trade.
On the other hand, a central bank (carrying trillions of dollars of long bonds with alike quantity of reserves) that is too slow to exit the zero bound might unhinge inflation
expectations and incur interest-on-reserves expenses to fight inflation in excess of in................................
20. McCauley and McGuire (2014).
21. See Federal Reserve Bank of New York (2014, pp. 22–23). Reverse repurchase agreements extinguish reserves by selling securities temporarily from the Fed portfolio. Term deposits shift the type of depositorybalance at the Fed from reserve balances to time deposits.
22. Potter (2013).
23. See footnote 6.

36 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014

Monetary Policy as a Carry Tradeterest earnings on its holdings of long bonds. And the above circumstances could arise
easily in tandem—if a protracted expansion of the central bank balance sheet against
deflation overshoots and inadvertently triggers an inflation scare.
The power to create money in the form of bank reserves uniquely positions a central
bank to address a negative cash flow problem. As a mechanical matter, a central bankcan create reserves to pay interest on reserves and managed liabilities. However, acentral bank committed to a low inflation objective must be sensitive to the eﬀect thatcreating reserve-money to stabilize the value of money might have on its credibility for
low inflation. A period in which the central bank is seen as having to create reserves(to pay interest on its liabilities) to stabilize the purchasing power of money will rightly
unnerve and very possibly unhinge inflation expectations, especially if the period is at
all protracted. Moreover, the creation of reserves to supplement negative cash flow puts
more interest-bearing reserves on the balance sheet without the acquisition of interestearning assets, worsening the cash flow problem. A central bank should position itself
to steer clear of ever having to create reserves to stabilize the purchasing power ofmoney.
Borrowing to pay interest on central bank liabilities via reverse repurchase agreements or term deposits, for example, is also problematic. Borrowing avoids potential
immobilization complications and perhaps some negative credibility consequences ofreserve creation. But borrowing to pay interest likewise expands interest-bearing liabilities on the central bank balance sheet without acquiring interest-earning assets.24
Negative cash flow is best addressed with retained earnings held in the central
bank’s surplus capital account. Sales of short-term securities held as surplus capitalto help pay interest on central bank liabilities would realize little if any capital loss
and would not disturb monetary policy operations. Retaining earnings on the front endof the monetary carry trade as surplus capital would facilitate greatly the operational
credibility of monetary policy against inflation by i) guarding against the central bankhaving to create reserves (or borrow) to pay its interest expenses and ii) mitigating criticism of its interest expenses by making clear that interest on reserves and managed
liabilities is paid for largely, if not in full, by net interest earnings from the front end of
the monetary carry trade together with interest earned on the back end.

V. Fed Surplus Capital and the Monetary Carry Trade
The Fed has long claimed independent authority over the size of its surplus capital
account and the transfers it withholds from the Treasury to maintain its surplus capital.
Furthermore, the Fed recognizes that the retention of transfers incurs no resource costfor the Treasury or taxpayers. Yet the Fed has chosen not to build surplus capital
above its modest longstanding level while remitting around $80 billion per year to theTreasury since 2010 on the front end of its monetary carry trade, even though Fed
assets will have risen from $1 trillion in September 2008 to around $4.5 trillion by theend of 2014, and $3 trillion of securities with an average maturity of over 10 years willthen be financed with market interest on reserves and short-term managed liabilities.
................................
24. Central bank borrowing to finance interest on its liabilities has no net eﬀect on aggregate bank reserves.

37

This section reconsiders the management of Fed surplus capital from the carry tradeperspective, and recommends that the Fed suspend transfers to the Treasury and build
up surplus capital to help secure operational credibility for its 2% inflation objective.
A. A Brief History of Fed Surplus Capital25
The Federal Reserve Act of 1913 requires that each member bank subscribe to thecapital stock of the Fed an amount equal to 6% of the capital and surplus of the memberbank. As member bank capital and surplus changes, the holding of stock is to be
adjusted. Only one-half of subscribed capital has ever been paid-in.
Initially, the Federal Reserve Act authorized the Fed to build up a surplus by retaining interest earned from its asset portfolio until surplus reached 40% of paid-in capitalof member banks. After surplus reached 40%, net earnings were to be transferred to
the Treasury as a “franchise tax.” In 1919 the Federal Reserve Act was amended toallow surplus to be raised to 100% of subscribed capital (twice paid-in capital). The
Banking Act of 1933 transferred half of Fed surplus, $139 million, to capitalize the
newly established Federal Deposit Insurance Corporation. In return, Congress abolished the franchise tax and allowed the Fed to retain all subsequent net earnings torebuild surplus.
The present basis for Fed-Treasury transfers was set in 1947 as part of what would
become the 1951 Fed-Treasury Accord freeing the Fed from its World War II interest
rate pegging policy. As part of the Accord, the Federal Reserve Board voluntarily resumed Fed-Treasury transfers as “interest on Federal Reserve notes,” transferring 90%
of net earnings to the Treasury as part of the agreement to float the Treasury bill rate.
Fed surplus capital continued to accumulate until 1959, when the Fed appealed to theprinciple that Congress had established in 1919. The Fed then voluntarily announced
its decision to maintain surplus at 100% of subscribed capital, to immediately transfer to the Treasury all surplus currently in excess of that amount, and to transfer tothe Treasury 100% of net earnings after maintaining surplus at the level of subscribed
capital thereafter.
Growth of member bank assets and liabilities yielded a 35% increase in subscribed
Fed capital from 1959 to 1964 at a time of federal budget deficits. And in 1964 the
Fed announced voluntarily an immediate 50% reduction in surplus to the level of paidin capital that added $524 million dollars to the amount transferred to the Treasury
in 1965. With minor exceptions, the Fed has transferred to the Treasury 100% of net
earnings after maintaining surplus at paid-in capital to this day.26
B. Fed Independence, Surplus Capital, and Fed-Treasury Transfers
Bringing matters up to date, the Federal Reserve Board asserts in the 2012 Annual
Report its independent authority over the size of the Fed surplus capital account and................................
25. This history of Fed surplus capital draws on Goodfriend and Hargraves (1983, pp. 11–14).
26. The 1993 Deficit Reduction Act contained a provision to transfer $213 million from the Fed surplus accountto help meet Federal Budget targets in fiscal years 1997–98 but the Fed was free to restore surplus to paid-in
capital shortly after fiscal 1998 by withholding of transfers to the Treasury. The 2000 Consolidated Appropriations Act directed the Fed to transfer $3.752 billion during fiscal 2000. Again the Fed was permitted to retain
earnings thereafter and shortly restored surplus to paid-in capital by withholding transfers to the Treasury.

38 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014

Monetary Policy as a Carry Tradethe transfer of excess earnings to the Treasury.27 The United States General AccountingOﬃce (GAO) has concurred. GAO (1996) states. . . Currently, and in the past, the levels of the surplus account have been discretionary because the requirement to have the surplus account equal to paid-in capitalhas been a matter of Federal Reserve policy; it was not required by law. . . Congress
may wish to determine whether these surplus accounts are necessary and, if so, set
permanently in law an appropriate amount for these accounts.28
Despite the GAO (1996) report’s suggestion, Congress has declined to set in law
requirements for Fed surplus and transfers, and continues to allow the Fed latitude to
determine independently its policy toward surplus and transfers to the Treasury. GAO(2002) repeats
The amount and timing of the Reserve Banks’ payments to the Treasury are notregulated by law. The Federal Reserve Board has discretion over the amounts theFederal Reserve System transfers to the Treasury.29
GAO (2002) reports the Fed’s rationale for retaining surplus capital
The Financial Accounting Manual for the Federal Reserve Banks says that the
primary purpose of the surplus account is to provide capital to supplement paid-in
capital for use in the event of loss. According to Board oﬃcials, the capital surplus
reduces the probability that total Reserve Bank capital would be wiped out by aloss as a result of dollar appreciation, sales of Treasury securities below par value,
losses associated with discount window lending. . . 30
Finally and importantly, the Fed comment letter on GAO (2002) emphasizes that. . . while the benefits of the surplus account can be debated, it is costless to thetaxpayer and the Treasury. . . 31
And GAO (2002) reports that the Congressional Budget Oﬃce agrees that. . . the transfer of surplus funds from the Federal Reserve to the Treasury has noimport for the fiscal status of the Federal government. . . Where the funds residehas no economic significance. Hence, any transfer of the Federal Reserve surplus
fund to the Treasury would have no eﬀect on national savings, economic growth,or income. [emphasis in original]32................................
27. Board of Governors of the Federal Reserve System (2012, p. 260).
28. Government Accounting Oﬃce (1996, pp. 67–68).
29. Government Accounting Oﬃce (2002, p. 1).
30. Ibid., p. 7.
31. Ibid., p. 24.
32. Ibid., p. 17.

39

Thus, there is general agreement that the retention of net interest earnings by the
Fed to build up surplus capital has no resource cost for the Treasury or taxpayers.
Briefly, the reasoning is this. If the Fed sells a security and transfers the proceeds ofthe sale to the Treasury, the Treasury loses the interest on that security, interest it would
have received from the Fed. It is as if the Treasury issued a new security to borrow thefunds in the first place. Hence, the reduction of Fed surplus yields no new revenue
for the government. Conversely, retaining earnings that would have been transferred
deprives the Treasury of no revenue because the acquisition of a security for the Fed’s
capital account and the transfer of that new interest is as if the Treasury retires an
outstanding security that it had borrowed against previously.
C. Why the Fed Should Retain Its Monetary Carry Trade Earnings
By the end of 2014 around 1/3 of the Fed’s $4.5 trillion of securities with an average
maturity of around 10 years will be financed with around $1.5 trillion of non-interest
bearing currency.33 Taking currency into account and the roughly 2.5% average coupon
interest per annum on Fed assets, Fed interest earnings alone could then finance at
most 3.75% interest per annum on the Fed’s $3 trillion of reserve balances and money
market liabilities. The Federal Open Market Committee projects a longer run federal
funds rate target slightly below 4% which, roughly speaking, the Fed would have to pay
on reserves and managed liabilities to finance its carry trade.34 Plausibly, interest paidby the Fed might have to go even higher as the economy gathers strength, especially if
the Fed allows inflation expectations to drift upward and must push short-term interest
rates much higher against an inflation scare. So currency does not provide as much ofa financial cushion for the Fed as one would like.
With a balance sheet such as that described above, the Fed would halt remittances
to the Treasury if interest rate policy considerations call for interest on reserves andmonetary liabilities to rise above 3.75%.35 The Fed could then draw down its modest
surplus capital to finance interest payments above 3.75%. After exhausting surplus................................
33. The demand for currency tends to grow with GDP over time. For instance, the stock of currency will havegrown from around $1 trillion at the end of 2008 to around $1.5 trillion by the end of 2014. The growing
demand for currency is financed by a drawing down of bank reserves, helping to reduce the interest expenseof the Fed’s monetary carry trade gradually over time. See Federal Reserve Bank of New York (2014, pp. 10–11).
34. Federal Open Market Committee (2014, p. 3), reports the average projection of the federal funds rate target
deemed appropriate at the end of 2015 and 2016, respectively, as 1% (with a 0% to 3% range) and 2.5% (witha 3/4% to 4.25% range), and over the longer run as slightly below 4% (with a range from 3.5% to 4.25%).
35. As a mechanical matter, in practice the Fed would halt remittances to the Treasury if interest income from its
portfolio were ever insuﬃcient to maintain surplus equal to paid-in capital after i) paying the 6% dividend on
member bank paid-in capital, ii) paying interest on reserve balances and money market liabilities necessary
for monetary policy, iii) funding other net operating expenses, and iv) retaining earnings to cover realized
losses on sales of domestic securities or revaluation losses on foreign securities, if any. At that point the Fed
could choose to create reserves, borrow via managed liabilities, or draw down its surplus capital to address its
negative cash flow problem. As an accounting matter, the Fed plans to record reserves and managed liabilities
created to oﬀset negative cash flow in a “negative liability account to the Treasury.” If the negative liability
account were ever to exceed the size of surplus and paid-in capital, the Fed would be technically insolvent.
The negative liability account would reflect an implicit interest-free loan to the Treasury with an implicit
promise that the Fed could retain future net interest income (seigniorage) to extinguish the implicit loan to theTreasury before restarting any remittances to the Treasury. See Eisenbeis (2011) and Fry (1993).

40 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2014

Monetary Policy as a Carry Trade

capital, the Fed would be forced to create reserves or to borrow via managed money
market liabilities to finance interest payments above 3.75%. In so doing, the Fed wouldgrow its interest-bearing liabilities without acquiring new assets, exacerbating the negative cash flow problem. As emphasized in Section IV.D., the credibility of the Fed’s
2% inflation objective would be jeopardized if the Fed were ever forced to create bankreserves or to borrow to pay interest on its liabilities.36
Fed remittances to the Treasury averaged around $80 billion per year from 2010
through 2013 as the Fed expanded its balance sheet to $4 trillion and earned the favorable 2% net interest margin on the front end of its carry trade.37 Had the Fed understoodits quantitative monetary policy at the zero bound as a carry trade, it would have had
good reason to withhold that $320 billion of net interest earnings to guard against everhaving to create reserves or borrow to meet its interest expenses, and to make the public
understand that interest on reserves and managed liabilities the Fed must pay eventually to sustain 2% inflation is paid for in large part, if not in full, by net interest earnedon the front end of its carry trade together with interest earned on the back end.38
Instead, the Fed has continued its long-standing practice of transferring to the Treasury 100% of net earnings after maintaining surplus at paid-in capital, a level geared tothe historically low exposures and risks on the Fed balance sheet.39 As of April 2014,
surplus capital was only about $25 billion, 0.66% of the Fed’s $4 trillion balance sheet,down from about 2% in September 2008 in spite of the Fed’s acquisition of enormousmonetary carry trade exposure and risk.40
It is not too late for the Fed to build up surplus capital in support of its monetary
carry trade. With short-term interest rates near zero, the front end of the Fed’s monetary carry trade should continue to generate around $80 billion per year in net interest
earnings. By retaining these earnings the Fed could build capital well above the cur................................
36. This concern is expressed by Swiss National Bank Governor Thomas Jordan, Jordan (2011, pp. 10–11) andby former Bank of England Governor Mervyn King, King (2012, p. 6).
37. Federal Reserve Bank of New York (2014, p. 7). Fed-Treasury transfers averaged around $30 billion per year
from 2002 to 2008 and rose to $40 billion in 2009 after the Fed began to expand its balance sheet during the2008 credit turmoil and the Great Recession.
38. International Monetary Fund (2013, pp. 27–28) projected as of April 2013 that the Fed would eventually lose
between 2% and 4.3% of US GDP as it normalized interest rate policy in coming years for a scenario similar
to the November 1993 to February 1995 Fed tightening. Interestingly and very roughly, presuming that the
Fed would exit the zero interest bound at the end of 2015, it would by then have transferred around $500
billion to the Treasury on the front end of its monetary carry trade, which is roughly around 3% of 2014 US
GDP.
39. By way of comparison, the Bank of Japan is authorized by law to retain 5% of net income each fiscal year
for its surplus account. In May 2014, while implementing its own monetary policy carry trade at the zerointerest bound to bring an end to deflation and achieve its 2% inflation objective, the Bank of Japan with theauthorization of the Minister of Finance moved to reserve 20% (rather than 5%) of net income.
40. Federal Reserve Bank of New York (2014, pp. 8–11) projects income net of interest expenses of the System Open Market Account to likely decline noticeably as the outlook for the economy and monetary policy
normalizes. But it finds that on a cumulative basis, net income earned from the Federal Reserve System’sbalance sheet policies is very likely to remain quite high, with SOMA net income exceeding pre-crisis levels
even under many alternative scenarios. Moreover, it concludes that “a temporary reduction in net income,even if large enough to prompt a halt to remittances to the Treasury, would not aﬀect the Desk’s capacity
to conduct open market operations or the FOMC’s ability to manage short-term interest rates (p. 11).” The
conclusion ignores risks to the operational credibility of the Fed’s 2% inflation objective emphasized in thispaper.

41

rent $25 billion surplus before interest rate policy exits the zero bound. Each additional$100 billion of surplus capital could finance an additional 3.3% interest on $3 trillionof Fed liabilities for a year, or 1% additional interest for three years. In its role as bankregulator, the Fed sees to it that depositories build up surplus capital commensuratewith their prospective financial exposures and risk. The Fed would do well to follow
its own guidance.

VI. Postscript: The Debt Ceiling and Fed Surplus Capital
The federal debt ceiling has the potential to complicate a suspension of Fed-Treasurytransfers. The retention of net interest income by the Fed for its surplus capital accountforces the sale of more debt if the Treasury doesn’t raise taxes or cut spending. The Fed
could buy an equivalent amount of Treasury debt in the open market for its enlarged
surplus account and return the accrued interest to the Treasury. So there need be no
net eﬀect on Treasury finances. However, Treasury securities acquired by the Fed still
count as public debt outstanding under the federal debt ceiling; so the sale of new debt
by the Treasury to accommodate the buildup of Fed surplus capital would absorb debt
capacity under the federal debt ceiling.
As it happens, legislation signed into law in February 2014 suspended the federal
debt ceiling through March 2015, allowing the Treasury to sell debt it deems necessary
until then.41 The Fed could use this window of opportunity to suspend transfers to theTreasury, build up surplus capital, and work with the fiscal authorities to facilitate thebuildup of its surplus capital after March 2015, perhaps by obtaining an exemption for
its holdings of Treasuries from the debt ceiling, at least until the Fed normalizes itsbalance sheet.

................................
41. Hook (2014).

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Monetary Policy as a Carry Trade

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