The Federal Reserve is losing money.
That means the American taxpayer is losing money.
In most instances, a business bleeding red ink has a big problem and could ultimately go under. Not so for the Fed. In fact, losing money isn’t a problem for the central bank at all. But it is a big problem for the US government.
According to the Federal Reserve’s quarterly report for Q2, the central bank reported a loss of $57.3 billion through the first half of the year. The Fed is on pace to lose over $100 billion in 2023.
Rising interest rates are a big problem for the Fed, as they are for other banks. The central bank earns interest income on the bonds it holds on its balance sheet. But the Fed also pays out interest to other financial institutions that park money there. The bonds it bought during multiple rounds of quantitative easing (QE) and still holds on its balance sheet were relatively low-yielding. But with rates much higher today, it is paying out interest at a much higher rate.
According to the Fed report, as of June 30, the central bank held roughly $5.5 trillion in US Treasuries with an average yield of 1.96%. It also held $2.6 trillion of mortgage-backed securities with an average yield of 2.20%. Meanwhile, the average interest rate the Fed paid on money it held, along with repo agreements and other operations averaged around 5%.
It’s also important to note that the Federal Reserve has shed almost $1 trillion from its balance sheet in quantitative tightening.
The results were predictable. Through the first half of the year, the Federal Reserve reported $88.4 billion in interest income. But it paid out $141.8 billion in interest expense. That adds up to a lot of red ink.
It’s also interesting to note that like many commercial banks, the Fed has substantial unrealized losses. If you mark all of the bonds held by the Fed to market value, the loss on paper is over $1 trillion. That’s more around 23 times the value of the central bank’s stated capital.
Bond portfolio losses are exactly what kicked off the financial crisis last March.
But none of this matters to the central bankers at the Fed.
Big Losses! So What?
The last time the Fed reported net operating losses was in 1915.
To put this 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, the central bank is on pace for a loss as large as the biggest gain in at least a decade.
Who suffers when the Federal Reserve loses money?
In most cases, a business feels the pain when a business loses money. But when the Fed loses money, the US government feels the pain. And ultimately, you and I foot the bill.
Under the Fed’s charter, the Fed remits its profits to the US Treasury. This helps pay down the massive federal budget deficits. When the Fed loses money, the Treasury loses its payday. That means even bigger budget deficits.
Bigger deficits mean the government has to raise taxes or borrow even more money. Either way, we pay. You either get a bigger tax bill or you pay the inflation tax when the Fed prints money to monetize the debt.
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 at the company’s assets. If this goes on long enough, the company 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.
A recent article by Alex Pollock published by the Mises Wire breaks it down using the Fed’s most recent balance sheet.
The CQFR reports a total capital of about $42 billion ($35.6 billion of paid-in capital from the member commercial banks and $6.8 billion of retained earnings, called “surplus”). But note: This total capital is much less than the $57 billion reported loss for the six months of 2023, to which must be added the loss for the later months of 2022 of $17 billion. This total $74 billion of accumulated losses by June 30 must be subtracted from the retained earnings and thus from total capital. But the Fed does not do this—it misleadingly books its losses as an asset (!), which it calls a “deferred asset”– a practice highly surprising to anyone who passed Accounting 101. Why does the Fed do this? Presumably it does not wish to show itself with negative capital. However, negative capital is the reality.
Here are the combined Fed’s correct capital accounts as of June 30, based on Generally Accepted Accounting Principles. They result in a capital of negative $32 billion:
Paid-in capital $36 billion
Retained earnings ($68 billion)
Total capital ($32 billion)
I sure do wish I could use my own accounting system when doing my taxes. But alas, I’m not special.
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. At some point, the Fed will be forced to cut rates and return to QE in order to manipulate the bond market so the government can keep borrowing. In other words, it will have to create more inflation.