The Fed Goes Under: Losses amid fiscal austerity will put the central bank in a political bind.

B.Before new trillion-dollar federal spending bonanzas became commonplace, the Federal Reserve’s announcement that it lost more than $700 billion might have grabbed some headlines. However, the loss was met with silence. Few Americans have noticed the enormous increase in both the scale and reach of the central bank or the dangers it poses to the US economy. As Federal Reserve-fuelled inflation becomes the number one political issue in the United States, that will change.

The Fed’s losses are due to a change in the way it does business. Before the 2008 financial crash, the central bank tried to control interest rates by buying and selling US bonds. A few billion in purchases or sales could move the entire economy, and this meant that the Fed, operating like a normal bank, could maintain a relatively small balance sheet of less than $1 trillion.

Since the financial crisis, the Federal Reserve, like other central banks in the developed world, has used a different playbook. It provides enough funds to satiate the entire banking world and seeks to adjust the economy by paying the banks more or less interest to maintain those funds. These payments prevent private sector interest rates from falling too low. When it first undertook this “floor” experiment, the Federal Reserve’s balance sheet ballooned to over $4 trillion. After the Covid pandemic, it approached $9 trillion.

A larger balance means higher risks. And the Fed has increased that risk by buying longer duration assets. Before the financial crisis, the Federal Reserve bought mainly short-term federal debt. Only about 10 percent of all US central bank-owned bonds lasted more than ten years. Now, that figure has risen to 25 percent.

In addition, beginning in 2008, the Fed banks began buying mortgage-backed securities, primarily from Fannie Mae and Freddie Mac. The Fed now owns more than $2.5 trillion of such mortgage bonds, nearly all of which mature in more than ten years. . Today, almost half of the Fed’s assets will not mature for another decade.

Such longer-term debt poses a particular danger. As the Fed raises interest rates, old low-interest debt bought by the central bank loses value, leading to losses in the hundreds of billions. Economists Alex Pollack and Paul Kupiec warn that the Fed’s actual losses are in excess of $1 trillion and will rise as interest rates continue to rise.

The Fed isn’t just losing value in its old assets; You have started paying more money than you receive, every day. The interest rate the Fed pays banks in its new “floor” system has risen to more than 4 percent, but its older Treasury and mortgage securities earn only about 2.3 percent. The longer high inflation and high rates continue, the more the Fed will lose.

During the pandemic, the Fed also started buying riskier assets than US bonds and semi-government mortgages. In 2020, it started backing junk bonds, car loans, student loans, and even credit card loans. The Fed also created a “Main Street” program to make direct loans to small and medium-sized businesses, including some non-profit organizations. This program has already suffered $50 million in credit losses, and a December report noted that the Fed expects to lose $1.4 billion in delinquencies and bad loans.

Like a normal bank, the Fed has capital: money provided by its owners in exchange for shares. Those “owners” are the private banks that have joined the Federal Reserve system and can earn dividends on their shares. Yet the Federal Reserve’s hundreds of billions of losses on Treasury bonds, mortgages and other programs have swamped its meager capital of $40 billion. From any normal perspective, the Fed is either submerged 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 Federal Reserve pumps trillions of dollars into the economy and then decides to keep about $6 billion for itself and its 23,000 employees. If you are low on cash, you can generate more.

But the Fed’s mammoth losses have real consequences. In recent years, the central bank has sent up to $100 billion a year in “profits” to the US Treasury, a not inconsiderable part of federal revenue. In September, the Fed’s gift to the Treasury was cut to zero for the first time in more than a decade. The Fed’s mounting losses mean it can stop paying money to the Treasury until 2030 or longer. Congress and the American people will be concerned when they learn that the Federal Reserve is paying tens of billions of dollars in interest to banks, including many foreign ones, directly from the new money it creates, even as it cuts off funding for the government. .

Congress will also miss the opportunity to treat the Federal Reserve as a piggy bank to attack. In 2015, Congress took $20 billion of the Federal Reserve’s capital to fund a highway bill. Congress also put the Consumer Financial Protection Bureau (CFPB) under the control of the Federal Reserve and allowed the agency to write its own paycheck using free money from the Federal Reserve. If the Federal Reserve’s losses continue, the CFPB’s $600 million annual budget could be threatened (although a recent federal court ruling striking down the budget stunt could stop it first).

The Fed will probably print more money to pay for its losses and interest and dividends to the banks. But keeping the money spigot flowing while inflation continues and the federal budget is under threat will put the Federal Reserve 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 could start “paying billions of dollars in interest to our largest financial institutions and nothing to taxpayers at a time of fiscal crisis”. austerity.” That day is here, and Chairman Powell no doubt regrets it.

Judge Glock is Director of Research and Senior Fellow at the Manhattan Institute, Contributing Editor of city ​​newspaperand the author of The Dead Pledge: The Origins of the Mortgage Market and Federal Bailouts, 1913–1939.