Dudley's Speech on Excess Reserves

William Dudley on July 29 admitted that the Fed is buying Treasury debt with banks' excess reserves.  When I read this, I thought "24-hour carry trade."  He said:

Third, the Federal Reserve is taking on some interest-rate risk in terms of its balance sheet. The excess reserves have an overnight maturity. These liabilities are being used to purchase longer-term assets. In principle, if short-term interest rates were to move up very sharply, the cost of funding could eventually exceed the return on the Fed’s assets. The bigger our balance sheet, the greater the amount of interest-rate risk we are assuming.

We have examined this issue in detail. Suffice it to say, it is conceivable that the Federal Reserve’s net-interest margin could be pinched in certain environments -- say if the economic recovery turned out to be very robust. But our analysis shows that it is extremely unlikely that the Fed’s net-interest margin will turn negative. In part, that is due to the fact that the balance-sheet risk associated with the interest-rate mismatch is offset to a large degree by the fact that the cost of much of the Fed’s liabilities—the amount of currency outstanding -- is zero. So when short-term rates rise, the cost of a significant portion of the Fed’s liabilities is unaffected.

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