Three Central Banks Watch, 6/29
Who pays when the Fed takes losses?
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.
… This fact is especially relevant given that the FOMC forecast has the federal funds rate at 3.4 percent by year-end 2022.
…In short, the Fed’s earning dynamics now resemble those of a typical failing 1980s savings and loan.
To understand what might happen, the authors have looked at the legislation that created the Fed as well as statements issued by the Fed.
The current Federal Reserve Board plan to manage losses is: (1) ignore any mark-to-market losses on its SOMA portfolio; (2) recognize realized losses on securities sales, if any; (3) monetize any operating losses and offset the liability on the Fed’s balance sheet by creating or increasing a deferred asset account. The Board has adopted this accounting policy notwithstanding an explicit Federal Reserve Act requirement that member banks be held liable for district reserve banks’ operating losses—a requirement still codified in law.
…It is impossible to imagine that the authors of the Federal Reserve Act would have approved of allowing the Fed to create an imaginary “deferred asset” as a mechanism to hide the fact that the Fed is depleting its cushion of loss-absorbing assets while paying banks interest on their reserve balances when the Act itself makes member banks liable for Federal Reserve district bank operating losses.
Monetizing operating losses will however enrich the Fed member banks that are supposed to be bearing the loss, while the public at large will face higher interest rates, higher unemployment, reduced growth, and the inflationary consequences of the new money printed to cover Fed losses. The Fed seems to be hoping that nobody notices.