In September, Fed revenues turned negative for the first time in years. A consequence that follows the restrictive monetary policy conducted for several months. We will look together if the FED’s losses can have more serious consequences such as a risk of bankruptcy.
What is the FED (US Central Bank) Balance Sheet?
Before explaining the source of losses, we will highlight the meaning of certain concepts. First, we will explain what the Fed’s balance sheet is made up of.
This is mainly composed of the following assets:
- State bonds
- Mortgage-backed securities
Here is the precise distribution within the balance sheet:
Government bonds are debts or claims issued by the government. These are used to fund government spending.
Mortgage-backed securities or “mortgage backed securities MBS” are valued by a set of mortgages and by the interest rates paid on the mortgages.
The evolution of the Fed’s balance sheet
The Fed’s balance sheet has increased significantly since 2008 following the quantitative easing program or “quantitative easing”. This consists of buying government bonds and also mortgage-backed securities. This principle makes it possible to inject more liquidity into the financial system. The purpose of monetary easing is to bring inflation back to around 2% when the economy falls into recession, it is a way of reviving growth.
Here is an overview of the scale of the balance sheet:
We are talking here about bringing inflation back to around 2%, because it is the major role of central banks to ensure price stability. The second mandate after price stability is to ensure full employment.
The opposite situation which is quantitative tightening (quantitative tightening) consists in withdrawing money from the financial system by proceeding to the non-renewal of a certain number of bond maturities. At the same time, we know the most used tool of the FED, the management of rates and therefore, the increase in rates during a monetary tightening. This process has been taking place since the beginning of 2022. This involves reducing the Fed’s balance sheet.
How does the Fed make money?
The FED derives its income from the bonds it holds, but also from the services it offers. Of course, it also has operating costs that it must cover with its income, and once everything is covered, it gives the government the surplus/profits.
For example, we can see that in 2020, government remittances were 86.9 billion and in 2021, 109.7 billion. Sums that are not negligible for the government.
The last time the U.S. central bank expanded its balance sheet during 2020-21 to kickstart the economy, it bought bonds with then-low rates and long maturities.
As the rates were low, the FED charges an average interest of about 1.7% as can be seen on the following graph.
However, this interest is less than what she has to spend since the short rates for the reserves are around 3.15%. Therefore, since the income is negative, there are no remittances to the federal government.
Are Fed losses a problem?
The FED has its advantages since it can establish its own rules which are different from a traditional bank. What is meant by this is that it performs an accounting operation of reporting the negative income as a deferred asset. To be more precise, this deferred asset amounts to approximately 2.9 billion dollars.
This implies that this loss will be covered in the future when the Central Bank can generate profits in the future. This is based on the principle that the FED will again lower rates in the coming years.
If you want more details, you can look at the projections for central bank remittances to the federal government. We can see that from 2025-2026, the discounts should be put in place again. This is just a projection of course.
At the same time, the deferred asset over the next 3 years should return to normal by 2026 to 2030. Normalizing monetary policy will take time.
The question that must be asked is whether the central bank can go bankrupt. If the situation were to worsen, the FED could reinstate the principle of printing money by creating even more debt in order to cover the losses. However, unlike in the past, this created money has no collateral such as gold for example. The only collateral remains the credibility of the central bank.
Printing money: the main cause?
We know that the injections of money in 2020 and 2021 created a lot of inflation afterwards. These injections were intended to bring inflation back to 2% by reviving the economy during the 2020 crisis. Today, the tools we used to revive the economy are also the cause of the economic slowdown and in good part of the cause of inflation. We therefore deduce a certain failure within the system which will take time to normalize again.
What are the impacts of deferred assets?
Already, what you need to know is that the losses will probably persist for the next few months. Yes, because as long as the Central Bank continues its monetary tightening policy, this means raising rates. Raising rates encourages traditional banks to place their money with the FED because the rates are more attractive. And as a result, there is less money available in the financial system.
The other thing you need to know is that the profits generated by the FED are redistributed to the government in order to finance expenditures and reduce the deficit. So it may have a stake in the fact that the government no longer receives these benefits for several months.
To conclude
The bottom line here is that the injections (bond purchases) have created some lapses in the U.S. Central Bank’s monetary policy system and it’s going to take some time to normalize. . Even if the FED is currently in the red, this should be rectified in the coming years.
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