Can the Federal Reserve lose money? If so, what does it matter? In fact, within two years of its creation, the Fed in 1915 had negative earnings of $141,000. To some, it did matter, because for that year its member banks received no dividends on their Federal Reserve stock. In fact, by law, the Fed could have assessed those member banks to cover the loss. It chose not to, for fear of discouraging state-chartered banks—which unlike national banks were not required to join the Fed—from becoming members of the system. Instead, the Fed’s 12 district banks paid greater attention to how to earn money and avoid losses. Some 100-plus years later, the Fed has a portfolio of nearly $9 trillion. What about avoiding losses?
With these issues vastly greater—the Fed having recently lost $540 billion in market value on its huge portfolio—Paul Kupiec, of the American Enterprise Institute, and Alex Pollock, of the Mises Institute (and also a member of the Federalist Society’s Practice Group on Financial Services & E-Commerce), have teamed up to raise and offer their answers to such questions. They write in an informative and well-argued AEI Economics Working Paper, “Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy.”
Kupiec and Pollock describe three sources of income/losses to which the Fed is exposed and how those are treated. How they are treated means, in the authors’ words, “The Federal Reserve will not fail.” Yet, who covers the tab?
First of all, Fed accounting recognizes neither unrealized gains nor losses on its portfolio. The net loss of $330 billion in market value of its assets experienced by March 31 is not part of its balance sheet. Nor is the estimated loss of $540 billion in market value to which it expanded by May 31.
The second is realized gains/losses. The Fed generally avoids these by holding its assets until they mature, close to the par value at which the Fed values them on its books.
The third source is operating expenses, the largest share of which has been interest rates. Rising rates affect its interest costs more than its earnings. In the first quarter of 2022, the Fed recorded net interest earnings of $32 billion. Kupiec and Pollock estimate that if rates were to continue to rise as the Fed currently forecasts, earnings would change to losses, to the point where they would no longer cover the Fed’s $9 billion in operating expenses. The “Fed would post an annual operating loss.”
In the evolving economic and financial conditions, these all raise numerous questions. Were rising rates to cause the Fed to go red, who would cover the costs? Could the Fed continue to pay banks for their excess reserves? Could the Fed afford its role as backstop to the market in repurchase agreements? To do these things, would the Fed monetize its costs, pumping the money supply while otherwise seeking to contract it?
Kupiec and Pollock look into these and related problems. Well worth the read, and surely important for policy makers to consider.
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