The Big Idea
The Federal Reserve is losing money
Stephen Stanley | October 14, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The September FOMC minutes included this rather innocuous sounding sentence: “As expected, Federal Reserve net income turned negative in September.” After a series of large rate hikes, the Fed is now paying more on reserves and reverse repo balances than the income it earns from its gigantic balance sheet. In practical terms, this may not affect monetary policy in the near term, but there may be longer-term repercussions for policy as well as political considerations. There will also be a considerable amount of confused discussion about this complicated topic, so it is worth learning the mechanics and details of the Fed’s projected net income.
Federal Reserve income and outflow
The Federal Reserve’s net income historically looked pretty simple. The Fed accrued operating expenses and captured income from its securities portfolio. Generally, the Fed would turn a “profit,” and is legally obligated to remit any income left over after expenses to the federal government.
Since 2008, the situation has been more complicated. The Fed’s portfolio of securities swelled after several rounds of QE, boosting income. At the same time, beginning in 2008, the Fed began to pay interest on reserves. When policy rates neared zero, from 2008 through 2015 and again in 2020 and 2021, this change made little difference. Even from 2017 to 2019, rates remained relatively low, so that interest paid on reserves remained a relatively small expense.
Prior to the financial crisis, when the Fed’s portfolio of Treasury securities was less than $1 trillion, annual Fed remittances to the Treasury were in the neighborhood of $30 billion. In the years after the financial crisis, that figure swelled, along with the size of the securities portfolio, to around $80 billion a year. When the policy rate moved above 2% in 2018 and 2019, the annual remittance slid, to about $70 billion in FY2018 and $53 billion in FY2019. However, the pandemic led to a return to zero rates and a massive increase in the portfolio. Remittances to Treasury jumped to $100 billion in FY2021 and were close to that level again in the just-ended fiscal year.
Higher interest expense
The rapid increase in policy rates has led to a stunning swing in Federal Reserve finances. To offer a snapshot of income and outflow, consider that in the week ended October 5, bank reserves were just below $3 trillion ($2.97 trillion), while the Fed also held $2.63 trillion per day in reverse RPs. Of the reverse RP total, roughly $300 billion was in the Foreign Official and International Accounts program and the rest was in the daily program that financial market participants are familiar with. The current interest rate paid on reserves is 3.15%, while the reverse RP rate is 3.05%.
At those levels and rates, the Fed would pay out an annualized $94 billion in interest on reserves and $80 billion in reverse RPs. Add in about $10 billion per year in operating expenses, and the current level of rates implies annual expenses of almost $185 billion.
Meanwhile, the System Open Market Account (SOMA) portfolio currently holds about $8.34 trillion in securities. To make the calculation simple, assume an average coupon of 2% on the holdings. In reality, as of June 30, the Fed’s Quarterly Financial Report noted that the average interest rate on Treasury securities was 1.96% while the average rate on federal agency and GSE MBS was 1.79%. So, 2% is a slight overestimate but is not too far from the accurate figure. In any case, 2% interest on a portfolio of $8.34 trillion yields about $167 billion annualized in income.
The last 75 bp hike in policy rates in September consequently pushed the interest expense for the Fed above its income, sending the Fed into a small deficit, as noted in the September FOMC minutes.
The Fed’s finances are poised to deteriorate significantly further. For the sake of argument, presume that the FOMC hikes rates by 75 bp in November and 50 bp in December, in line with the median FOMC dot projection released in September, and that the level of reserves plus reverse RPs and the securities portfolio both shrink by $80 billion a month (the stated caps are $95 billion per month, but the Fed is not going to come close to hitting its MBS caps). In that case, interest expense would surge to a $234 billion annualized pace, while income would decline slightly to $162 billion. Factoring in operating expenses, that would suggest an annual loss rate of over $80 billion.
If the FOMC then hiked by an additional 75 bp in the first four months of 2023, as I project, and the portfolio and reserves plus reverse RPs shrunk by another $300 billion ($75 billion a month), then the Fed would be running a loss of just over $100 billion at an annualized pace.
Accounting for losses
Research and legal staff at the Federal Reserve Board explored the negative income scenario in great detail in the years after the financial crisis, offering a blueprint for how it will work in practice. As net income has dwindled, remittances to the Treasury have eroded. Once net income turns negative, we move into some creative accounting. The Federal Reserve will write an IOU to Treasury called a “deferred asset” for the amount of the drop in net income. These IOUs would accumulate for the duration of the period over which the Fed’s net income is negative. Then, once the Fed’s net income turned positive again, the Fed would begin paying off these IOUs. No actual money would be remitted by the Fed to Treasury until the deferred assets are paid off. After the deferred assets are all canceled out, then the Fed would go back to remitting net income after expenses back to Treasury. In essence, the Fed is committing future earnings to offset current losses.
It is important to note that the Fed is not a private company. An entity that theoretically has the ability to print unlimited amounts of currency can never be insolvent or bankrupt. An accumulated deferred asset, even if it grows quite large, need not impact the Fed’s operations or the conduct of monetary policy. As a result, negative net income for the Fed should largely be a non-event for financial markets and the economy.
Having said that, I would not go so far as to say that a large deferred asset would be entirely irrelevant. One can envision a scenario where deferred assets accumulate to a very large number. If we assume that the ultimate destination for the Fed’s balance sheet is a contraction of roughly $2.5 trillion from the current level, which would take the combined level of bank reserves and reverse RPs to about $3.1 trillion and the Fed’s securities portfolio to $5.8 trillion, then the Fed could still be experiencing negative net income at some plausible levels of policy rates. My own view is that the FOMC will need to hold the funds rate at the peak level until the summer of 2024, which may not be far from the time when the Fed stabilizes the balance sheet.
Assume for the moment that the Fed is still paying 5% on reserves and reverse RP balances when the balance sheet stabilizes at the levels noted above. In that scenario, the Fed would still be posting negative net income in the neighborhood of a $50 billion annual pace. The loss at a 4% policy rate would be close to $20 billion annualized. Finally, at a 3% policy rate, the Fed would post modest positive net income (likely around $10 to $15 billion a year).
While 3% may still seem like a relatively high policy setting in the context of the period between the financial crisis and the pandemic, consider that the FOMC thinks that the longer-run neutral rate is 2½%, not much lower. My own view is that longer-run neutral is more likely higher, perhaps in the neighborhood of 3%. And this all assumes that the Fed is entirely successful at bringing inflation all the way back down to 2%. A scenario where the funds rate stays at or above 3% for years to come is not entirely implausible.
The problem that the Fed faces is that it bought trillions of dollars of fixed-rate long-term securities at extremely low yields. In effect, much like a hedge fund that finances such positions with overnight repo, the Fed is “funding” itself at the overnight rate. Unlike a hedge fund, the Fed never has to worry about a margin call, but it could be years before its portfolio earns more income than its funding costs. Also, unlike a hedge fund, the Fed’s aim is to maximize the economy’s performance, not to make a profit. So, buying these assets at rock-bottom yields arguably served an important role in shepherding the economy through the perilous pandemic period.
In any case, working through the arithmetic, it is not impossible that the Fed could wrack up deferred assets of several hundred billion dollars over the next two to four years, if policy rates climb above 5% and stay there for an extended period. Then, if policy rates settle out near a plausible “neutral” range, the Fed may only be earning positive net income in the $10 to $30 billion per year range, which could leave the Fed in the hole for a decade.
Again, there is no reason that this has to matter in the real world, given the way that the Fed and Treasury have worked out the accounting. However, one can imagine that the shadow of a large deferred asset could have ripple effects. Here are a few possible issues to consider:
- Size of the balance sheet. A number of analysts have suggested that the Fed will need to retain a much larger balance sheet than Chair Powell and other officials have suggested. There has been some talk that the Fed will have to end its balance sheet reduction in a matter of a few months. I am skeptical of this line of thought, but as long as policy rates are above 4%, the larger the size of the balance sheet, the bigger accumulated deferred assets will be. Could this become an argument, at the margin, in favor of a smaller balance sheet?
- MBS sales. Eventually, if the Fed wants to return to a Treasuries-only portfolio, it is likely going to need to sell MBS. At current mortgage rates, redemptions are shrinking fast and will not allow a pace of runoff anywhere near the Fed’s cap of $35 billion per month. This would argue for eventual outright sales, a proposition that was mentioned again as possible in the September FOMC minutes. However, if the Fed sells MBS securities, it will have to record substantial losses on those securities, further inflating and accelerating its net income deficit. Could the shadow of a mammoth deferred asset weigh on the FOMC’s debate next year of whether to sell MBS?
Politics. You can be sure that some lawmakers are eventually going to notice that the Fed is no longer remitting cash to the federal government. And when they ask why, the answer will be something along the lines that the Fed is paying massive amounts of money to banks and money market funds participating in the reverse RP program. One can certainly envision this creating a stir, with some firebrand legislator grilling Chairman Powell at a Congressional hearing. This may be too arcane to hit the public’s radar, but a populist could spin the story in a way that would not reflect well on the Fed.