Before new trillion-dollar federal spending bonanzas became a regular occurrence, the Federal Reserve’s announcement that it lost over $700 billion might have garnered a few headlines. Yet the loss met with silence. Few Americans have noticed the huge increase in both the scale and the scope of the central bank or the dangers that it poses to the American economy. As Fed-driven inflation becomes the Number One political issue in America, that will change.
The Fed’s losses owe to a shift in the way it does business. Before the 2008 financial meltdown, the central bank tried to control interest rates by buying and selling U.S. bonds. A few billion in purchases or sales could move the whole economy, and this meant that the Fed, which operates much like a normal bank, could keep a relatively small balance sheet of under $1 trillion.
Since the financial crisis, the Federal Reserve, like other developed-world central banks, has used a different playbook. It provides enough funds to satiate the entire banking world, and it seeks to adjust the economy by paying banks more or less interest to hold those funds. These payments keep private-sector interest rates from dropping too low. When it first undertook this “floor” experiment, the Fed’s balance sheet exploded to more than $4 trillion. After the Covid pandemic, it approached $9 trillion.
A larger balance sheet means greater risks. And the Fed has added to that risk by purchasing longer-duration assets. Pre–financial crisis, the Fed bought mainly short-term federal debt. Only about 10 percent of all the U.S. bonds owned by the central bank lasted longer than ten years. Now, that figure has risen to 25 percent.
Moreover, starting in 2008, Fed banks began buying mortgage-backed securities, mainly from Fannie Mae and Freddie Mac. The Fed now holds more than $2.5 trillion of such mortgage bonds, and almost all those mature in over ten years. Today, nearly half the Fed’s assets won’t come due for another decade.
Such longer-term debt poses a particular danger. As the Fed pushes up interest rates, the old, low-interest debt that the central bank purchased loses value, leading to those hundreds of billions in losses. Economists Alex Pollack and Paul Kupiec warn that true Fed losses are over $1 trillion and will increase as interest rates keep rising.
The Fed is not just losing value on its old assets; it has started paying out more money than it takes in, every day. The interest rate that the Fed pays to banks in its new “floor” system has risen to over 4 percent, but its older mortgage and Treasury securities earn only about 2.3 percent. The longer the high inflation and high rates continue, the more the Fed will lose.
During the pandemic, the Fed also started buying riskier assets than U.S. bonds and semipublic mortgages. In 2020, it began supporting junk bonds, auto loans, student loans, and even credit-card loans. The Fed also created a “Main Street” program to supply direct loans to small and medium-size firms, including some nonprofits. This program has already suffered $50 million in loan losses, and a December report noted that the Fed expects to lose $1.4 billion in defaulting and bad loans.
Like a normal bank, the Fed has capital—the money provided by its owners in exchange for stock. Those “owners” are the private banks that joined the Federal Reserve system and that can earn dividends on their stock. Yet the Fed’s hundreds of billions of losses on Treasuries, mortgages, and other programs have swamped its meager $40 billion in capital. From any normal perspective, the Fed is underwater or bankrupt. Of course, unlike most banks, the Federal Reserve can survive such losses. It is the only institution in America that prints its own budget. Every year, the Fed pushes trillions of dollars into the economy, and then decides to keep $6 billion or so for itself and its 23,000 employees. If it is short on cash, it can just make more.
But the Fed’s gargantuan losses come with real consequences. In recent years, the central bank has sent up to $100 billion a year in “profits” to the U.S. Treasury, a not-insignificant share of federal revenue. In September, the Fed’s gift to the Treasury dropped to zero for the first time in more than a decade. The Fed’s growing losses mean that it may stop paying money into the Treasury until 2030, or longer. Congress and the American people will become concerned when they learn that the Fed is paying tens of billions of dollars in interest to banks—including many foreign ones—directly out of new money that it creates, even as it cuts off funds to the government.
Congress will also miss out on the chance to treat the Federal Reserve as a piggybank to raid. In 2015, Congress took $20 billion of the Fed’s capital to fund a highway bill. Congress also put the Consumer Financial Protection Bureau (CFPB) under the Federal Reserve’s purview and let the agency write its own paycheck using free Fed money. If Fed losses continue, the CFPB’s $600 million annual budget could be threatened (though a recent federal court ruling striking down the budget gimmick might stop it first).
The Fed will likely print more money to pay for its losses and the interest and dividends to banks. But keeping the money spigot flowing as inflation continues and the federal budget comes under duress will put the Fed in a political bind. A decade ago, Jerome Powell, then a member of the Federal Reserve Board, warned that under the expanded floor system, the Fed might start “paying billions of dollars of interest to our largest financial institutions and nothing to the taxpayer in a time of fiscal austerity.” That day is here, and Chairman Powell is doubtless lamenting it.
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