Who Owns Federal Reserve Losses and How Will they Impact Monetary Policy?
Among Federal Reserve officials and many economists, it is fashionable to argue that any losses the Federal Reserve should suffer, no matter how large, will have no operational consequence. Is this true? If so, how does the Fed account for its losses and stay solvent? And who ends up paying for these losses? As the Fed executes its strategy to reign in run-away inflation, the answers to these questions take center stage as the Fed has already experienced mark-to-market losses of epic proportions and will soon post large operating losses, something it has never faced in its 108-year history.
We estimate that, between December 31, 2021 and the end of May 31, 2022, the Federal Reserve lost $540 billion in market value on its huge portfolio of investments in Treasury bonds and mortgage securities. To put this loss in perspective, $540 billion is equivalent to 60 percent of the value of the Federal Reserve System’s entire asset holdings on September 1, 2008, just prior to the onset of the financial crisis. $540 billion is more than 13 times the Federal Reserve System’s recently reported consolidated capital of $41 billion meaning that the market value of the Fed’s outstanding liabilities—primarily member bank reserves and Federal Reserve notes—exceed the market value of the assets the Fed owns by about half a trillion dollars. As interest rates go higher, this loss increases. Moreover, if the Fed’s inflation-fighting campaign eventually requires short-term interest rates to rise above 2.7 percent, we project the Federal Reserve will experience net operating losses, in addition to its mark-to-market losses.
Unlike banks and other financial institutions, no matter how big the losses it may face and how negative its true capital position, the Federal Reserve will not fail. But if losses, however large, can’t end the Fed, who pays for these losses? Will the Fed’s shareholders be hit in some fashion or will the losses be monetized and contribute to spiraling inflation? Should member banks be paid interest when the interest payments cause Federal Reserve losses? In recent years, questions like these have been irrelevant because the Fed has made very large profits. But this year is different.
Federal Reserve officials try to downplay the gravity of these issues. For example, at a recent Federal Reserve Bank of Atlanta Financial Markets Conference, Federal Reserve Bank of Cleveland president Loretta Mester said that losses would have no impact on the Fed’s ability to conduct monetary policy, but admitted they could raise “communication challenges” for the system. This rather cavalier treatment of massive Federal Reserve losses is curious since it is potentially at odds with the way Federal Reserve losses should be treated according to the Federal Reserve Act. Moreover, given the large interest income banks earn on their reserve balances, the issue of burden sharing of Federal Reserve System losses may become much more contentious as the Fed executes its inflation-fighting policies in the coming months.
The real story of how the Fed accounts for losses, how the losses impact monetary policy, and who ultimately pays for these losses is a complicated one. The details are in some little-known provisions of the Federal Reserve Act of 1913, in more recent Federal Reserve Board policy decisions regarding the Fed’s accounting standards, in legislation changing its dividend and capital surplus policies, and in its post-financial crisis decision to pay interest on banks’ reserve accounts.
The Federal Reserve Act stipulates that Federal Reserve shareholders—the member banks– should bear at least some Federal Reserve System losses, but to date, this has never happened. “Innovations” in accounting policies adopted by the Federal Reserve Board in 2011 suggest that the Board intends to ignore the law and monetize Federal Reserve losses, thereby transferring them indirectly through inflation to anyone holding Federal Reserve notes, dollar denominated cash balances and fixed-rate assets.
Federal Reserve System Current and Prospective Losses
In the Federal Reserve System’s most recent financial statements for the quarter ending March 31, 2022, the fair value note to the statements shows a total unrealized capital loss of $458 billion during the quarter on the Fed’s $8.8 trillion book value of the Fed’s System Open Market Account (SOMA) securities holdings. This loss took the fair value of the portfolio from a mark-to-market gain of $128 billion on December 31, 2021, to a mark-to-market loss of $330 billion on March 31.
With interest rates continuing to increase, we estimate that the Fed’s unrealized capital loss grew by an additional $210 billion, bringing the Fed’s total unrecognized capital loss to an estimated $540 billion as of May 31, 2022. Losses continued to grow through mid-June and should the Fed maintain its plan to continue raising interest rates to fight inflation, these losses will only increase. If the Fed was a bank or other regulated financial institution, it would be closed because it is already deeply economically insolvent.
In addition to the deleterious impact of rising interest rates on the market value of its SOMA portfolio, rising interest rates will sharply reduce the Fed’s net interest income. In the first quarter of 2022, the Fed reported net interest earnings of $35 billion which, when netted against expenses, yielded a reported operating income of $32 billion, a figure that excludes the mark-to-market loss on its securities portfolio.
As interest rates continue to increase, the Fed net interest revenue and operating income will decline as the Fed pays higher interest rates on $3.3 trillion in member bank reserve balances and its nearly $2.3 trillion (as of June 1) in reverse repurchase agreements while it earns interest on the largely fixed-rate securities its SOMA portfolio. According to our estimates, if short-term interest rates were to reach 2.7 percent, the Fed’s net interest income would no longer be sufficient to cover its approximately $9 billion in annual operating costs, and the Fed would post an annual operating loss. This fact is especially relevant given that the FOMC forecast has the federal funds rate at 3.4 percent by year-end 2022.
With annual inflation currently running at 8.6 percent, 3.4 percent may not be a high enough short-term interest rate to tame inflationary pressures. Federal Funds futures and several bank economists project that policy rates will need to rise to 4 percent or higher in 2023. Ignoring market-to-market losses on its SOMA portfolio, and absent any realized losses from SOMA asset sales, we project that the Fed will post an annual operating loss of $62 billion if short-term rates rise to 4 percent. A $62 billion loss is 150 percent of the Federal Reserve system’s current capital.
This unenviable financial situation in which the Fed has placed itself—huge mark-to-market investment losses and declining, and eventually negative operating income—is the predictable consequence of the balance sheet it has created when the stance of Fed monetary policy transitions to fighting inflation. The balance sheet now combines paying rising rates of interest on bank reserves and reverse repurchase transactions after more than a decade of Fed quantitative easing and zero interest rate policies that stuffed the Fed’s balance sheet with low-yielding long-term fixed rate securities. In short, the Fed’s earning dynamics now resemble those of a typical failing 1980s savings and loan.
Does the Federal Reserve Need a Positive Capital Cushion?
In 1913, the members of the 63rd Congress which passed the Federal Reserve Act, decreed that the Federal Reserve’s 12 distric
Article from Mises Wire