WASHINGTON - The Federal Reserve's total assets on its balance sheet have more than quadrupled to $3.8 trillion since 2008 amid a massive bond-buying effort. And there are few signs that the growth will stop soon.
That could put the finances of the world's most powerful central bank at risk if historically low interest rates were to rise sharply something top Fed officials said they do not expect but that critics warn is very possible.
It also could inhibit the ability of officials to respond to future economic and financial crises.
"It's really pretty cut-and-dried as far as the arithmetic goes: If you buy bonds and interest rates go up, you're going to take a capital loss on those bonds," said James D. Hamilton, an economics professor at the University of California-San Diego. "The more they buy, the bigger their balance sheet, the bigger the loss they're going to face."
Federal Reserve policymakers wrap up a two-day meeting Wednesday and are expected to continue purchasing $85 billion a month in low-interest-rate Treasury bonds and mortgage-backed securities as part of the Fed's third and longest such program to stimulate economic growth.
The continuing lackluster recovery from the Great Recession, combined with the economic hit from the partial federal government shutdown this month, have analysts predicting that there's little chance Fed policymakers will vote to scale back the program until early 2014 at the soonest, even with Wall Street booming.
Investors drove the Dow Jones industrial average to an all-time high Tuesday it rose 111.42 points, or 0.7 percent, to 15,680.35.
"The expectation that the Fed remains clearly on hold is the catalyst for this march higher," said Quincy Krosby, a market strategist at Prudential Financial.
The Standard and Poor's 500 index rose 9.84 points, or 0.6 percent, to 1,771.95, its seventh record high this month..
If the Fed keeps behaving as it's expected to, then its balance sheet will swell to more than $4 trillion. As the number gets bigger, the risks also rise.
"The Fed stands to lose a lot of money, and by a lot of money, I mean hundreds of billions of dollars," said Rep. Mick Mulvaney, R-S.C., who has raised those concerns with Fed Chairman Ben Bernanke. "It is not hyperbole to suggest the next big bailout could be of the Federal Reserve."
But Bernanke said that there's no need to worry and that any losses incurred by the Fed probably would be offset by more than $300 billion in interest the Fed has earned on its expanded holdings in recent years.
RATES STAY REASONABLY LOW
The Great Recession and financial crisis caused so much economic damage that the 100-year-old Fed has had to attempt new ways to try to stimulate growth.
Normally, the Fed simply adjusts the short-term interest rates it sets for banks to make overnight loans to one another with money they keep at the central bank. A lower interest rate reduces the incentive to park money at the Fed, giving banks an incentive to lend it instead and create economic activity.
But with those interest rates near zero since 2008 and the economy still struggling, the Fed in 2009 began an unconventional approach - buying long-term Treasury bonds and mortgage-backed securities. The idea was to push down long-term rates, such as mortgages, to get the economy moving.
During three rounds of Fed bond-buying, the latest beginning in September 2012, interest rates have tumbled to record lows before rising in recent months as investors feared the Fed was preparing to reduce the program.
But the bond-buying is risky for the Fed. It purchases bonds from banks and pays for them by adding a credit to the bank's reserves held at the Fed. Banks store their excess reserves at the Fed, which currently pays 0.25 percent in interest.
SHORT TERM VS. LONG TERM
In effect, the Fed is borrowing money at very low interest rates to buy the bonds, said Marvin Goodfriend, an economics professor at Carnegie Mellon University.
"In the short term, it's a money-maker," he said, noting the long-term bonds the Fed purchased pay about 2.5 percent interest while it has to pay only about 0.25 percent interest on the money it used to buy them.
"The borrowing cost is cheap right now. Those borrowing costs are going to rise."
When interest rates begin rising, the Fed will have to pay a higher rate on bank excess reserves. That will eat into the bottom line.
At the same time, rising interest rates will reduce the value of the bonds, which make up about 94 percent of the Fed's assets. As of last Wednesday, the Fed held about $2.1 trillion in Treasury securities and about $1.4 trillion in mortgage-backed securities. Its total assets, which include loans and foreign currency holdings, were $3.8 trillion.
"If the Fed were to sell those bonds for a loss, who makes up the loss? The U.S. taxpayer makes up the loss," said Peter Schiff, chief executive at Euro Pacific Capital.