How can a bank with the power to create money out of thin air manage to lose money and become insolvent? The Federal Reserve can do it. Here is how.
The Fed is losing money at an accelerating rate. Based on generally accepted accounting principles (GAAP), the Fed soon could soon be considered insolvent.
The central bank’s unique financial position results from a history of bad decisions combined with its current attempt to correct for past mistakes. Higher interest rates are having a devastating effect on the Fed’s cash flow as well as its capital.
The Fed’s cash flow consists mainly of interest it receives from its $8.3 trillion holdings of securities and interest the Fed pays on its liabilities to banks. The Fed’s second-quarter financial report lists interest income of $46 billion from those securities. The receipts amount to an annualized interest rate of roughly a 2 percent.
The Fed’s second-quarter interest payments were $34 billion. The difference between interest earned and interest paid left the Fed with a positive net interest margin of $12 billion. The average cost to the Fed of paying interest was at an annual rate of only about 0.50 percent. The low cost was due to the second-quarter federal funds rate of only 0.8 percent.
So long as the Fed was making a profit, it turns most of its earnings over to the U.S. Treasury. Over the past decade, the Fed transferred an average of $80 billion a year toward reducing federal deficits.
However, for the third quarter of this year, the Fed will no longer be profitable. Although the Fed’s quarterly report will not be available until the end of this month, the Fed’s interest rate margin likely turned negative. With little change in the Fed’s holdings, interest earned from its portfolio is likely to be close to the second quarter, roughly $46 billion. However, with the third-quarter fed funds rate at 2.2 percent, more than twice the second quarter rate, we should expect a significant increase in interest payments turning its cash flow from positive to negative.
Whatever the Fed lost on net interest income in the third quarter, its fourth-quarter losses will be even greater. The Fed’s recent interest rate hike, and the potential for another in mid-December, could produce an average fourth-quarter fed funds rate of 3.75 percent. While some estimates place the Fed’s cash flow outlay at $60 billion a year, I estimate a much higher deficit.
As if the cash flow losses were not bad enough, as interest rates rise, the value of fixed-rate securities declines, reducing the market value of the Fed’s $8.3 trillion portfolio. All the securities the Fed purchased over the past 13 years at low interest rates are still on the Fed’s books. As interest rates rise, the market value of those securities is rapidly declining. If the Fed had to mark its portfolio to market value, as most financial businesses must do, the Fed’s net worth could be negative, raising the issue of it being insolvent.
The Fed has no one to blame but itself for this mess. Beginning in 2009, the Fed went on a Thanksgiving-type Black Friday buying spree purchasing securities. The spree only ended in July 2022. During its buying binge, the Fed purchased so many securities that banks were not able to find profitable loans and investments for much of their new funds. This should have been a clear signal to the Fed that most of its purchases were unnecessary. Instead, banks left theses excess funds as interest-bearing deposits with the Fed.
While interest rates remained low, the Fed’s interest payments to banks were modest. As interest rates increased, banks deposits with the Fed became the main reason the Fed’s interest expense soared.
The Fed compounded its mistakes by holding interest rates far below market levels for the past 13 years. In using all of its monetary tools to promote low interest rates, the Fed discouraged savings and promoted speculative behavior. Now, as interest rates are moving closer to market levels, the problems associated with the Fed’s policy mistakes are becoming apparent.
One clear implication of the Fed losing money is that it will no longer send money to the U.S. Treasury. Hence, the Fed’s losses mean federal deficits will be worse than when the Fed was profitable.
How will financial markets respond to a Fed that is rapidly losing money and moves toward insolvency?
The Fed claims its negative financial report will have no impact on its monetary policy and, by implication, no serious impact on the economy. Cash-flow deficits and insolvency from negative net worth can be handled with adjustments in accounting. “Deferred assets” will be added to the Fed’s balance sheet with the assumption they will be paid for when interest rates decline and the Fed is solvent.
Will accounting gimmicks work? We all hope so. However, when buying many trillions of dollars in excess securities, the Fed failed to consider the ultimate financial implications. Similarly, it is doubtful Fed members will consider the implications of an extended period of losses and insolvency. The more we attempt to use novel accounting solutions to paste over the Fed’s past mistakes, the more we might have to brace for a longer period of adjustment to return to normal.
The broader implications of the Fed’s mismanagement of its finances are far from clear. There is always the prospect of a day of reckoning. As the Fed moves to restore market interest rates, we are about to discover how serious the reckoning will be.
