By: Ken Green & Phil Kernen
One byproduct of the massive Federal Reserve balance sheet in a zero percent interest rate environment has been its tremendous cash-generating capabilities. In 2021, the Fed sent the U.S. Treasury $100 billion in excess earnings. Following interest rate increases engineered in 2022, that balance sheet has become an enormous money loser with no good options.
A central bank that issues the world’s reserve currency doesn’t come cheap. The United States Federal Reserve Bank plans to spend $7.5 billion in 2022. These costs include more than 24,000 staff across the Federal Reserve Board of Governors in Washington DC ($1.0 billion), a 12-branch reserve bank system ($5.4 billion), and the Bureau of Engraving and Printing charged with ensuring an adequate supply of currency in circulation ($1.1 billion).
As the issuer of a national currency, a central bank typically doesn’t require funding from the Treasury. As part of its role in setting interest rates, the Federal Reserve has historically owned a small portfolio of interesting-bearing U.S. Treasury securities providing it with interest income. At the same time, the Fed had minimal interest-bearing liabilities, so the interest earnings on its assets were more than enough to cover its operational costs.
As we explained in an earlier article, Fed policy to pursue four bond purchasing programs since the Great Financial Crisis (quantitative easing) led to holding more than $8 trillion in interest-bearing assets, providing abundant cash income. At the same time, it accumulated more than $5 trillion in interest-bearing reverse repurchase agreements and bank reserves, all of which required cash payments from the Fed. The rest of its liabilities is cash in the economy, and the Fed kept the difference to cover its operational costs and sent any excess back to the U.S. Treasury.
Flipping the relationship
Multiple interest rate increases this year reversed that arrangement. Fed balance sheet assets pay mostly fixed coupon income, while its liabilities move with interest rate changes. As rates rose, so did the liability cash payments, while asset cash earnings remained unchanged.
Each week the Fed posts an unaudited balance sheet with accompanying notes. On note 6 is a line labeled Earnings remittances due to the U.S. Treasury. The Fed remitted cash to the U.S. Treasury weekly when earnings were positive. On the release for September 8, 2022, that line item turned negative – the Fed paid more weekly interest expense than it earned from interest income.
Until earnings turn positive again, the Federal Reserve will record a deferred asset and not send any more money to the Treasury. The negative balance was small initially, only $165 million, but it has multiplied since. The most recent release on December 15 showed a negative cumulative balance of $14.3 billion, averaging more than $1.0 billion in weekly negative cash flow. The Fed is losing more money than it costs to run its operations, and it’s only begun.
In July 2022, the Federal Reserve analyzed how high the deferred asset balance could go. Its baseline estimate showed a peak of $60 billion, an easy achievement if you believe, as we do, that rates will need to rise further still to arrest inflation and stay there for some time to bring it back down. The upper edges of its forecast showed a deferred asset as high as $180 billion.
The Fed has two options to reduce operational losses. Both carry material downsides. First, they could lower interest rates which would slow and possibly reverse the large and growing interest expenses on its liabilities. The risk is that inflation stays higher for longer while economic and job growth turn negative. Second, it could begin selling assets from its balance sheet leading to the reduction of associated liabilities and interest costs. The drawback in doing so would require crystalizing a portion of the $1.125 trillion in unrealized losses on the Fed balance sheet at the end of September 2022, an action the Fed will likely avoid at all costs.
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