Fed on track for tens of billions in losses amid inflation fight

NEW YORK, Oct 28 (Reuters) – The Federal Reserve’s aggressive campaign to contain inflation leaves it on track for tens of billions or more in losses over the next few years, bank experts say central.

These losses will not hamper the central bank’s ability to conduct monetary policy but could, over time, expose it to friction on the political front. Moreover, it is difficult to know how much money the Fed could lose given the very unstable economic outlook.

The Fed started losing money last month, sooner than many expected, including the Congressional Budget Officewhich saw no losses from the Fed in a forecast released in September.

The Fed tracks negative revenue with an accounting measure it calls a deferred asset. The size of this shortfall now stands at $5.3 billion and while there is great uncertainty about the future magnitude and duration of this loss, there are rough estimates.

“The deferred asset account is expected to peak in the $100 billion to $200 billion area and it will likely take 3 to 4 years to recover,” said Derek Tang, an economist at research firm LH Meyer Monetary Policy Analytics.

A Federal Reserve research paper from July aimed to basic expectations a view that the Fed would operate under a loss for three to four years and set aside $60 billion in deferred assets, based on the monetary policy outlook then in place. But the Fed document also said the loss could reach $180 billion if the central bank were to raise rates much more than expected by midsummer.

The expected trajectory of losses is “bad, but not too bad,” said William English, a former senior Fed official who is now at Yale University.

FED PAYS TO PARK CASH ON THE SIDE

The Fed is losing money due to the mechanics of monetary policy. The federal funds rate target range is its primary tool for achieving its employment and inflation goals, but that rate is managed by two other central bank rates.

By paying interest to a mix of banks, money market funds, and others, the Fed keeps the fed funds rate within the desired range. Under its current regime, the Fed now pays a rate of 3.05% on more than $2 trillion in funds poured into the Fed’s repo facility daily, for example.

That’s a big change from how the Fed managed its key rate before the 2007-09 financial crisis, when reserve levels were relatively low and it paid no interest on them. The current system was guided by a legal change allowing the Fed to pay interest on reserves and its need to expand its toolkit to manage short-term rates in a system where stimulus efforts in central bank bond buying have created much higher reserve levels in the banking system.

The Fed finances its operations through the services it provides to banks and through the interest on the bonds it holds. It hands over to the Treasury everything it needs to operate. Last year it was $109 billion, while in 2020 it was just under $90 billion.

The Fed’s challenge now is that its aggressive efforts to bring inflation down from forty-year highs has pushed the federal funds rate range from effectively zero in March to between 3% and 3.25%, and it is expected to raise rates between 4% and 5% next year.

It is now paying more interest than it takes in from its bond holdings and other sources of income, and as it tightens monetary policy further, the magnitude of the loss will only increase. Meanwhile, it is also looking to reduce the size of its balance sheet, which means a reduction in interest income from securities.

The deferred asset the Fed uses to record its loss is like an IOU to the government. The Fed expects that when it returns to profitability, it will repay this deferred asset and cover the loss. Officials have been adamant that losing money does not affect the Fed’s ability to operate.

POLITICAL FRICTION

Fed experts warn, however, that some political leaders may in future question the loss, especially since it is driven by a monetary policy toolkit that pays banks to hoard cash. . Many of these banks are foreign, and some think the Fed might wonder why its policies are helping banks at a time when they are making credit more expensive for ordinary Americans.

English noted that the Fed’s operational losses are “not a significant economic issue,” but that the political side of the equation could become a flashpoint.

In a June diary he wrote with former Fed second in command Donald Kohn they flagged the deficits as a potential flashpoint. The money the Fed has returned over the years has been touted as a deficit-cutting tool, and the lack of those funds could become a problem.

That said, the revenue situation the Fed currently faces is unique. For many years, he handed over money to the government as required by law, rather than building up a nest egg he could draw on when income turned negative. Some hope that Congress will remember this arrangement before suing the central bank.

“The Fed would be sitting on $800 billion in retained earnings if it didn’t have to return it to the Treasury,” Tang said.

Reporting by Michael S. Derby

Our standards: The Thomson Reuters Trust Principles.