The Big Idea
Corporate profits and the Fed
Stephen Stanley | July 28, 2023
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.
Corporate earnings for the second quarter appear to have exceeded expectations. So once again, businesses have proven quite adept at managing expectations. The federal government also publishes reports on corporate profits, derived in part from corporate earnings announcements. The government gauge of profits surged during the pandemic but tumbled in the last quarter of 2022 and the first quarter of this year. But much of the recent drop comes from a surprising place: the Federal Reserve. As a result, the government measure is likely exaggerating the degree of pain for corporate America.
As part of the National Income and Product Accounts (NIPA), the Bureau of Economic Analysis (BEA) calculates corporate profits. Ultimately, the main source for these figures are data compiled by the IRS from corporate income tax returns. However, those data are only available with a lag, so the BEA has to extrapolate from the latest available tax data to create quarterly estimates for the most recent periods. Those estimates are derived from Census Bureau figures for various industries as well as the tabulations from a sample of corporate earnings reports. Thus, the BEA’s corporate profits series should be broadly in line over time with the quarterly shareholder reports that financial markets focus on, but the two do not necessarily have to be entirely consistent.
The BEA’s gauge of corporate profits sank in the first half of 2020 as Covid led to widespread lockdowns. Profits rebounded in the second half of 2020 and then surged in 2021, posting a 22.6% year-over-year advance. They leveled off in 2022 but remained elevated, roughly 25% higher than in 2019 (Exhibit 1).
Corporate profits declined sharply in the fourth quarter of 2022 and first quarter of 2023, however, sinking by a combined 7% over the six months. That gave back about a third of the nominal gains achieved in the prior three years.
Exhibit 1: Corporate profits surged after Covid but have declined lately
This profit downturn suggests that corporate America is in considerable distress. But a feature of the BEA data that may not be well understood accounts for a large proportion of the recent swings.
The BEA’s tally of corporate profits includes the Federal Reserve. The Fed earns income on its SOMA securities portfolio and pays interest on reserves and funds in the RRP facility. As the portfolio grew in 2020 and 2021, the Fed’s interest income swelled in proportion, while its outflow was minimal given near-zero policy rates. In fiscal years 2021 and 2022, the Fed remitted $100 billion a year back to Treasury, its net income above and beyond the central bank’s costs.
The rapid rate hikes since March 2022 have pushed the Fed’s interest payments sharply higher. In the third quarter of last year, remittances to Treasury ended, as the Fed’s net income evaporated, and the central bank quickly descended deeply into the red, “losing” over $100 billion at an annual rate in the first quarter of this year. The Fed reports its income and interest expense publicly, so it is straightforward for the BEA to calculate “profit” figures for the central bank (Exhibit 2).
Note that the Fed is not marking its securities holdings to market, so paper losses do not factor into these profit estimates. If the Fed were a bank, its entire portfolio would be in the held-to-maturity bucket.
Exhibit 2: Federal Reserve “profits”
The Fed’s accounting of its net income is asymmetric. When the Fed earns a “profit,” it remits any income net of operating costs back to Treasury. And there are real-world implications. These remittances are equivalent to tax revenues and reduce the budget deficit and the Treasury’s borrowing needs on a dollar-for-dollar basis.
As an aside, the Fed indirectly monetized Treasury’s extra borrowing during the pandemic. The Treasury borrowed trillions of dollars to fund a variety of massive stimulus programs. The Fed then implemented QE, buying a similar amount of Treasuries, and in the process expanding the money supply/stock of bank reserves by trillions. From the perspective of the federal government, the Fed funded the spending, providing the public with the extra cash that they would otherwise have had to use to buy the additional Treasury borrowing as well as remitting the interest that the Treasury would ordinarily have had to pay to the public back into the government’s coffers.
In any case, once the Fed’s net income turns negative, the accounting changes. Some central banks in that scenario have to go to the government hat in hand and ask for money to balance their ledgers. However, Treasury and the Fed worked out a different arrangement. When the Fed is in deficit, it writes an IOU to Treasury, a “deferred asset.” These deferred assets accumulate until the Fed gets back into the black, at which time, the IOUs are “paid off” over time.
This is a neat deal for the Fed and for the federal government. When the Fed is losing money, it writes the government an IOU and then prints money to pay for its own costs. So, the Fed’s current efforts to shrink the level of excess reserves are actually being partially offset by the money it prints to fund itself. The bottom line from an economic perspective is that positive net income for the Fed is at the margin expansionary but negative net income is irrelevant, since the Fed creates what amount to worthless IOUs. They are worthless because the Fed is already obligated to remit all of its excess profits to the Treasury anyway, so, in reality, the Fed would never actually pay Treasury extra cash to pay off the deferred assets.
In the context of corporate profits, the point of this extended discussion is to establish what may already be obvious: when considering the health of the business sector and corporate profits, the fiscal performance of the Fed can be safely ignored.
Corporate profits excluding the Federal Reserve
When we exclude the Federal Reserve from the corporate profits estimates, the picture is considerably different (Exhibit 3). The ascent of corporate profits is actually even larger than for the total figure and the peak comes later, in the fourth quarter of last year. Corporate profits did fall noticeably in the first quarter this year, even after excluding the Fed’s losses, but the drop was about half as large. First quarter profits excluding the Fed fell less than 3% from the high as opposed to 7% for the overall series.
Exhibit 3: Corporate profits excluding the Federal Reserve
Once we extract the effects of the Fed’s income swings, the BEA’s measure of corporate profits suggest that corporate America remains in extraordinarily good shape, barely off the sharp gains achieved in 2021 and 2022. In light of the first quarter fall in profits, it will be interesting to see preliminary second quarter estimates, which are due out on August 30. The corporate earnings statements so far suggest that businesses continue to hold up reasonably well.