Could the U.S. central bank go broke?

By Pedro da Costa and Ann Saphir

WASHINGTON/CHICAGO (Reuters) – The U.S. Federal Reserve’s journey to the outer limits of monetary policy is raising concerns about how hard it will be to withdraw trillions of dollars in stimulus from the banking system when the time is right.

While that day seems distant now, some economists and market analysts have even begun pondering the unthinkable: could the vaunted Fed, the world’s most powerful central bank, become insolvent?

Almost by definition, the answer is no.

As the monetary authority, the central bank is the master of the printing press. It can literally conjure up money at will, and arguably did exactly that when it bought about $2 trillion of mortgage-backed securities and U.S. Treasuries to push down borrowing costs and boost the economy.

The Fed’s unorthodox steps helped it generate record profits in 2010, allowing it to send $78.4 billion to the U.S. Treasury Department. But its swollen balance sheet leaves the central bank unusually exposed to possible credit losses that could create a major headache at a time of increasing political encroachment on the Fed’s independence.

Asked about the issue of potential losses during congressional testimony on Friday, Fed Chairman Ben Bernanke suggested the risks were minimal. If liabilities on the Fed’s balance sheet were to exceed its assets, it would only be so because of rising interest rates in the context of a thriving economy, he suggested.

“Under a scenario in which short-term interest rates rise very significantly, it’s possible that there might come a period where we don’t remit anything to the Treasury for a couple of years. That would be I think a worst-case scenario,” Bernanke said. Customarily, the Fed submits surplus profits from its operations back to the Treasury’s coffers.

But the Fed’s newfangled policy steps and the potential for credit losses raises, for some experts, the prospect that the Treasury may actually be forced to “recapitalize” the Fed — economist-speak for what others might call a bail-out.

That would be a strange role reversal given the Fed’s efforts to ease monetary policy by buying the Treasury’s debt, and it could raise a political firestorm from lawmakers who believed all along the Fed was putting taxpayer money at risk.

A PAUPER ON PAPER

Varadarajan Chari, an economics professor at the University of Minnesota and a consultant to the Minneapolis Fed, says that at some point during its exit from easy monetary policies, the Fed actually may go broke — at least on paper.

“The most obvious exit strategy is, when inflation starts to pick up, to stop and reverse asset purchases,” he said. “That’s likely to include requiring the Fed in an accounting sense to see a significant accounting loss.”

The Fed now holds just over $1 trillion in Treasuries, Chari noted, and if inflation rose by..STORY HERE