Higher Interest Rates Raise Risk of Future Fed Losses

The Federal Reserve’s plans to raise interest rates aggressively to combat high inflation could have an overlooked and uncomfortable side effect for the central bank: capital losses.

The potential for losses hinges on obscure monetary plumbing.

The Fed’s $9 trillion portfolio, sometimes called a balance sheet, is full of mostly interest-bearing assets — Treasury and mortgage-backed securities — with an average yield of 2.3%.

On the other side of the ledger — the liability side of the Fed’s balance sheet — are bank deposits held at the Fed known as reserves, which are also interest bearing, as well as currency in circulation.

In the old days before the 2008 financial crisis, the Fed kept its portfolio relatively small, at less than $1 trillion. Its main liability was the amount of money in circulation.

The Fed shifted reserves up and down in incremental amounts if it wanted to lower or raise short-term interest rates.

That crisis changed everything.

The Fed cut interest rates to zero and purchased large quantities of bonds, flooding the banking system with reserves to support the economy.

The Fed also revamped the way it managed interest rates. With a large portfolio, it left the banking system flush with more reserves and switched to a new system of controlling short-term rates by paying interest on those reserves.

The central bank aggressively ramped up this type of help for the economy again when the Covid-19 pandemic hit in early 2020. The balance sheet had nearly doubled when officials ended such purchases this past March.

For the past decade, one side effect of its new approach for controlling interest rates was that, because of relatively low short-term rates, the Fed earned more money on its securities than it paid to banks as interest on reserves.

Every year, the Fed handed over the surplus to the Treasury Department after covering its operating expenses. This March, it remitted $109 billion to the government from its earnings in 2021.

But if the Fed now has to raise interest rates a lot to fight inflation, “they’ll have losses,” said William English, a former senior Fed economist who is now a professor at the Yale School of Management.

When exactly that occurs depends on the level of rates and the size of the balance sheet — specifically, the point where it pays more in interest on its $3.4 trillion in reserves than it earns on the $8.5 trillion in securities it owns.

For now, that break-even level of the Fed’s benchmark rate — the point at which the Fed would pay more in interest than it earns — is around 3.5%, according to projections from economists at Deutsche Bank and Morgan Stanley.

The federal-funds rate is currently in a range between 0.75% and 1%, and investors in interest-rate futures markets currently expect rates to rise above 3% in about a year.

The Fed is set to begin shrinking its asset portfolio next week by allowing more securities to mature without reinvesting the proceeds into new ones.

Over time, that will help minimize the prospect for losses because it will reduce the amount of interest-bearing reserves at the Fed, said Seth Carpenter, global chief economist at Morgan Stanley.

So what happens if the Fed runs a loss? The central bank can’t run out of money. It wouldn’t have to turn to Congress, hat in hand. Instead, it would relabel such a loss by creating a new entry on its balance sheet called a “deferred asset.”

In years where the Fed again has a surplus, it wouldn’t hand over surpluses to the Treasury Department until it had first paid itself back, erasing the deferred asset.

Would this constrain the Fed’s operations? No. Losses have “no direct implication for monetary policy,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank.

But it could create a political headache for the central bank — potentially at a time of growing unhappiness with the Fed if, for example, inflation stays high or if the Fed’s efforts to combat rising prices puts the economy into a slump.

The prospect of capital losses could have implications both in the short run and beyond.

Officials have discussed potentially selling mortgage-backed securities in the future to more quickly accomplish their objective of holding mostly Treasurys on its balance sheet. But any such sales could incur losses because the value of those bonds has fallen with the Fed signaling higher rates ahead.

Those losses “would not entail any operational challenges” but “would pose communications challenges,” Cleveland Fed president Loretta Mester said at a conference earlier this month.

Mr. Carpenter, a former Fed economist, said central bank officials aren’t likely to “intentionally make a bad policy decision to avoid having losses.”

But he said that when forced to choose between two policy options that would have roughly equivalent economic outcomes, “you might choose the one that doesn’t give you the headache of having to explain why you had losses.”

Over the longer term, capital losses could underscore a risk of the Fed’s asset purchases that some critics of those purchases say ought to make the Fed more skeptical about their use going forward.

“Because this is a real cost to taxpayers, you’ve taken on real risk. That risk is a cost that should be considered,” said Bill Nelson, chief economist at the Bank Policy Institute, an industry group.

If Congress gives the Fed grief around declining income, or threatens its operational independence, then Fed officials in the future could become less willing to use those tools as aggressively as they have in the past.

Briefing memos and transcripts of Fed policy meetings 10 years ago, when officials embarked on what was then their largest bond-buying stimulus program, show that concerns about the political fallout from potential losses factored into debates over how to manage the runoff of the Fed’s balance sheet.

At a December 2012 meeting, Fed chairman Jerome Powell, who was then a governor, flagged one hazard: that the Fed could end up paying billions of dollars of interest to our largest financial institutions and nothing to the taxpayer in a time of fiscal austerity. “To me, that’s a whole lot more than a communications problem.”

At the same meeting, Janet Yellen, who was then the Fed’s vice chairwoman and is now Treasury secretary, conceded the risk but pointed to greater harm if the Fed didn’t secure its economic objectives.

“Losses on the central bank’s balance sheet can raise questions among politicians and the public about a central bank’s performance,” she said. “But prolonged failure to meet the central bank’s mandate can be just as damaging to its reputation and independence.”

With inflation today running far above from the Fed’s 2% target, Mr. Powell and his colleagues are likely to take the same attitude today that Ms. Yellen did 10 years ago.