The Federal Reserve is awash in red ink, with operating losses at America’s central bank recently punching through the psychological barrier of $100 billion, prompting worry that taxpayers will suffer.
Some experts project losses to double to $200 billion before peaking while others warn the problem will persist at least as long as high inflation continues to be a problem.
How Did We Get Here?
The Fed rarely loses money.Normally, it makes a profit on its operations, which include issuing the currency and providing banks with financial services. When it does turn a profit, the Fed returns some of its excess cash pile to the U.S. Treasury in the form of remittances, which benefits taxpayers.
But soaring inflation forced the Fed into an unusually quick interest rate hiking cycle, which also impacted the Fed’s own liabilities, forcing the central bank to pay out more on interest on its outstanding debt.
On the other side of the equation, the Fed’s assets are mostly long-duration, meaning that its portfolio of U.S. Treasuries and mortgage-backed securities and other instruments are locked in at lower interest rates that don’t adjust up.
Amid the rate-hiking cycle, the Fed started losing money in September 2022 and—about a year later—the red ink has swelled into a tidal wave of crimson.
“The Fed was the first bank to get on the wrong side of the interest rate trade and racked up a bunch of assets that pay low interest—and took on a bunch of liabilities at high interest rates,” E.J. Antoni, a public finance economist at the Heritage Foundation, told The Epoch Times in an interview.
Years of the Fed’s easy money policies, in particular the quantitive easing program that followed the 2008–2009 financial crisis and again during the pandemic, have swelled the Fed’s balance sheet.
But with interest rates catapulting from near zero last year to over 5 percent currently, Mr. Antoni said the Fed is trying to reduce the size of its balance because it’s too big relative to interest rates and is costing the Fed too much money to service.
How Deep Will The Hole Get?
Opinions vary about how much deeper the hole is going to get.William English, a former senior central bank staffer now at Yale University, said he sees a “peak” loss of around $200 billion by 2025.
Meanwhile, Derek Tang of forecasting firm LH Meyer said the loss is likely to be between $150 billion and $200 billion by next year.
Mr. Antoni said that the true figure will in part depend on how much the Treasury has to borrow.
That’s because the Fed is basically paying high interest rates (and racking up losses) to prevent roughly $5 trillion from getting into the banking system and fanning the flames of inflation.
“What is essentially happening with these losses, they are—not entirely but primarily—being driven by the fact that the Fed is paying interest to keep money sterilized so that it can’t get into the banking system—somewhere around $5 trillion worth,” he said, noting that the $5 trillion would end up getting multiplied by banks due to fractional reserve system, which basically lets banks create more money out of thin air.
The Fed’s loss-making operations are helping keep a lid on the money supply—and so inflation.
“That’s not to say it eliminates inflation, obviously, we’ve had a lot, but it minimizes the impact of inflation,” Mr. Antoni said.
“The problem is that [the Fed] is paying that interest daily” and is having to pay whatever the market rate is every single day.
“There’s a very good chance that we’re going to continue to see these steep losses at the Fed for years, not just months,” Mr. Antoni warned.
What Are The Implications?
Taxpayers are already taking a hit.The Fed’s profits are normally sent to the Treasury in the form of remittances—and that source of government revenue has dried up.
The Fed’s profitability “directly affects how much money the Treasury has to borrow, because remittances used to be a small but reliable form of revenue for the Treasury,” Mr. Antoni said.
“And now, they’ve gone away,” he said of the money that the loss-making Fed is now not supplying to the Treasury, at a cost to taxpayers, who are basically on the hook for more government borrowing to make up the shortfall.
The Fed uses an accounting procedure that books losses in a given year as a “deferred asset” that’s equal to its cumulative losses.
When the Fed returns to profitability, it would retain profits to pay down the deferred asset and once the deferred asset has been reduced to zero, that’s when the Fed would resume remitting its profits to the Treasury.
“The money that used to flow to the U.S. Treasury in remittances is now instead flowing to the U.S. commercial banking system and money market funds. The interest-bearing liabilities for the Federal Reserve are interest-bearing assets for U.S. banks, money market funds, and entities like that,” she wrote.
She also noted that central banks differ from commercial banks in that they can basically continue to make losses and keep operating with no immediate end in sight.
“Unlike a commercial bank, a central bank can just keep functioning with negative equity and indefinite losses,” Ms. Alden wrote.
“Positive equity is just an imaginary line to preserve the idea of central bank independence, and can be maintained with accounting gimmicks. It’s like standing somewhere deep out in the wilderness right on some unguarded part of the border between Canada and the United States; the line might as well not even be there,” she added.
However, she added that while the near-term implications of the Fed’s losses aren’t that big, it’s a different story over the long-term. She expressed concern about a “fiscal spiral” taking place in the United States, describing it as a combination of high deficits, high debts, and high interest rates on those debts that combine to create higher inflation and expansion of the money supply.
“The Federal Reserve entering into negative tangible equity is just another piece of that process unfolding, since it contributes to larger federal deficits by taking away Treasury remittances,” she wrote.
Inflation is a key part of the puzzle about what happens going forward, according to Mr. Antoni, as high prices force the Fed to keep interest rates high to cool demand—but add to its losses on high-interest liabilities.
The inflation beast “is not dead, not by any stretch of the imagination,” Mr. Antoni said, cautioning against the view held by some that the inflationary dragon has basically been slain.
