The Fed Is Losing Money; So What?
The Fed’s inflation fight is doomed to fail. Raising rates and shrinking its balance sheet to tame the inflation dragon means more federal government debt.
The Federal Reserve is bleeding money and losses are mounting.
So, what does this mean? Is the central bank in danger of going under?
In fact, losing money isn’t a problem for the Fed at all. But it is a big problem for the US government.
The Fed booked a $126 billion loss in February. This was primarily due to higher interest rates. The central bank must pay commercial banks interest on reserve balances it holds for them, along with interest on reverse repurchase agreements. As the Fed raises interest rates, it increases its own interest expenses, while the interest generated by the bonds held on the balance sheet remains unchanged. Meanwhile, quantitative tightening decreases its balance sheet and reduces its interest income.
By law, most of the Fed’s net income is paid to the US Treasury. In 2022, the Federal Reserve reported a net income of $58.4, but the central bank’s net income went negative in September. It was the first operating loss since 1915.
To put February’s net loss in perspective, the largest yearly gain over the last 10 years was in 2021 when the Fed reported a $104 billion net income. In other words, February’s loss was bigger than the biggest gain in at least a decade.
This is obviously a problem for the US government, as it is a revenue loss for the Treasury. That means the huge budget deficits will grow even bigger.
But what about the Fed? Isn’t losing money a problem for the central bank?
It certainly would be for a normal bank. But the Fed isn’t a normal bank.
As Mises Institute Senior editor Ryan McMaken put it, “The de facto reality of the Federal Reserve is that it is a government agency, run by government technocrats, that enjoys the benefits of being subject to very little oversight from Congress.”
If a normal business loses money, it must cut costs, sell assets, borrow money, or take other actions to stop the losses. If it loses enough money, it will eventually eat away that the company’s assets and it will become insolvent. Sustained losses ultimately mean bankruptcy.
The Fed doesn’t have to do any of these things. In fact, it can lose money year after year and go right on doing business as if there were no losses.
Because we live in a world where the Federal Reserve gets to make its own accounting rules. And according to its own accounting rules, any net loss magically turns into a “deferred asset.”
[I]n the unlikely scenario in which realized losses were sufficiently large enough to result in an overall net income loss for the Reserve Banks, the Federal Reserve would still meet its financial obligations to cover operating expenses. In that case, remittances to the Treasury would be suspended and a deferred asset would be recorded on the Federal Reserve’s balance sheet.”
Under this scheme, an operating loss does not reduce the Fed’s reported capital or surplus. The bank simply creates an “asset” on its balance sheet out of thin air equal to the loss and business continues as usual. (This is kind of like money printing.) As losses mount, the size of this “asset” will grow.
There is no limit to the size of this “deferred asset” and no time limit on its existence.
Once the Fed returns to profitability, it will retain profits in order to reduce the amount of this imaginary asset. In other words, the US government won’t get any money from the Fed until this “asset” is zeroed out. At that point, the Fed will resume sending money to the federal government.
This has no real impact on the Fed, but it does mean the US government will see a long-term reduction in revenue resulting in a budget deficit higher than it otherwise would have been as long as the Fed is losing money.
The American Institute for Economic Research sums it up.
Simple accounting logic suggests that if the federal budget deficit is reduced when the Fed earns revenues in excess of expenses and remits these profits to the US Treasury, Fed losses should increase the reported federal budget deficit. This is especially true since Federal Reserve System losses now include the hundreds of millions of dollars of off-budget funding it is required to transfer to run the Consumer Financial Protection Bureau. If the current accounting rules remain unchallenged, the Congress could pass new legislation requiring the Federal Reserve to fund any number of activities off-budget without any impact on the reported federal budget deficit.”
This isn’t good news for a government already buried in debt and running massive budget deficits month after month. It means the US government will have to borrow even more money that the Fed will ultimately have to monetize.
This is yet another reason the Fed’s inflation fight is doomed to fail. Raising rates and shrinking its balance sheet to tame the inflation dragon means more federal government debt. That puts more pressure on the central bank to prop up the government’s borrow-and-spend policies. And this will ultimately necessitate lower interest rates and quantitative easing.
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