NEW YORK, Sept 15 (Reuters) – The Federal Reserve’s losses have topped $100 billion, central bank data released on Thursday showed, and they are likely to climb much higher before the red runs out.
The Federal Reserve continues to pay out more in interest costs than it earns from the interest it earns on its bonds and from the services it provides to the financial sector. Although there is considerable uncertainty about how it will all play out, some observers believe the Fed’s losses, which began a year ago, could eventually double before easing.
William English, a former senior central bank official now at Yale University, said he expects a “peak loss” of around $200 billion by 2025. Meanwhile, Derek Tang of forecasting firm LH Meyer said the loss would likely be between $150 billion and $200 billion by next year.
The Fed records its losses in a so-called deferred asset, an accounting measure that indicates what it will ultimately need to cover in the future before it can return to its normal practice of returning its profits to the Treasury. It is very rare for the Fed to lose money. However, at the same time, the Central Bank has repeatedly stated that the situation does not in any way affect its ability to conduct monetary policy and achieve its goals.
The Fed losing money was no surprise given its aggressive campaign to raise interest rates, which has seen the federal funds rate rise from near zero in March 2022 to the current range of 5.25% to 5.50% . As inflation pressures ease, the Fed is widely expected to be finished or close to raising interest rates.
LIQUIDITY DESTRUCTION
But that doesn’t mean that losses will stop increasing, because the current level of short-term interest rates will drive up net negative income for a longer period of time. Instead, the losses will eventually stop, largely due to the Fed’s continued balance sheet contraction to coincide with its interest rate hikes.
The Fed has been buying bonds aggressively during the coronavirus pandemic and its immediate fallout, shedding about $1 trillion in Treasury and mortgage bonds over the last year. Fed officials have suggested that there is more work to be done on this front and that the central bank will therefore need to spend less on interest rates because it is draining liquidity from the financial system. Financial markets are aiming for a stop in the second or third quarter of 2024.
The liquidity sought by the Fed comes primarily in the form of bank reserves and inflows to the central bank’s reverse repo facility. Through these tools, the Fed pays a mix of banks, money managers and others to park cash on its books. So when liquidity shrinks, it costs less for the central bank to tie up the remaining funds, even if its key interest rate doesn’t change.
“The pace of losses will decrease even if interest rates remain high because reserves and (reverse repurchase agreements) decline as securities expire and new purchases of securities earn the new, higher interest rates,” English said. But he acknowledged that “this is all very difficult” given how many factors and uncertainties are at play.
Bank reserves have fallen by around $1 trillion since their peak in late 2021 and stood at $3.3 trillion as of Wednesday. Meanwhile, daily outstanding reverse repo holdings have fallen from more than $2 trillion a day between June 2022 and the end of June this year to $1.5 trillion as of Thursday. Money market trading firm Curvature Securities said in a research note this week that it is possible that by the end of next year all the money from reverse repo transactions will have disappeared and the facility will be back to the level it was at just over two years ago .
POLITICAL PRIZE
For some time now, the Fed has been returning significant amounts of money to the Treasury, and that money is being used to reduce government deficits.
James Bullard, the former head of the St. Louis Fed, said in an interview Wednesday that he was “concerned” about the central bank’s losses and “it would be better not to do this.” He said it probably would have been better if the Fed had kept some of the $1 trillion it gave the Treasury over the last decade to cover the kind of losses it is now dealing with, but he pointed out that this was not the system that Congress had put in place.
Once the Fed stops losing money, it will take years before it is able to take the deferred assets off its books and return cash to the Treasury. In 2022, the Fed returned $76 billion after returning $109 billion in 2021.
Furthermore, these high incomes were associated with the very low rates of the time. It remains an open question whether the Fed will be able to return to this situation, although some in the central bank, particularly New York Fed President John Williams, are optimistic that it can happen.
Reporting by Michael S. Derby; Edited by Paul Simao
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