Economy

Fed poised for losses of tens billions amid inflation fight By Stocksak


© Stocksak. FILEPHOTO: A U.S. Federal Reserve building facade is topped by an eagle, Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Michael S. Derby

NEW YORK (Stocksak) – The Federal Reserve’s aggressive campaign to rein in inflation leaves it on track for tens of billions, if not more, in losses over the next few years, central bank experts say.

Those losses will not impede the central bank’s ability to conduct monetary policy but could over time expose it to friction on the political front. What’s more, getting a handle on how much money the Fed might lose is difficult given the highly unsettled economic outlook.

The Fed began losing money last month sooner than many expected, including the Congressional Budget Office who saw no Fed losses in a September forecast.

Negative income is accounted for by the Fed using an accounting measure it calls a “deferred asset”. The size of that shortfall now stands at $5.3 billion and while there’s great uncertainty about the future size and duration of that loss, there are some ballpark estimates.

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

According to the July Federal Reserve research paper, the baseline expectation was that the Fed would suffer a loss for three or four years and have a $60 billion deferred asset. This is based on the current monetary policy outlook. However, the Fed paper warned that the loss could be as high at $180 billion if central bank raises rates more than was expected in the middle of summer.

The expected path of losses are “bad, but not too bad,” said William English, a former top Fed staffer who is now at Yale University.

FED PAYS FOR PARK CASH ON IDELINES

The mechanics of monetary policies are causing the Fed to lose money. The Fed’s main tool to achieve its goals and inflation goals is the federal funds rate target range, but this rate is managed by two central bank rates.

The Fed maintains the federal funds rate within its desired range by paying interest to a mixture of banks, money funds, and other institutions. As part its current regime, the Fed is now paying a 3.05% rate on over $2 trillion money funds have been pouring daily into the Fed’s reverse repo facility, for example.

This is a significant change from the Fed’s policy rate management prior to the 2007-2009 financial crises. In those days, reserve levels were relatively low and the Fed did not pay interest. The Fed’s ability to pay interest on its reserves was a result of a legal change. It also needed to expand its toolkit to manage short term rates in a system where central banks have been buying more bonds to stimulate the banking system.

The Fed funds its operations by providing services to banks and through interest on bonds it holds. The Fed gives the Treasury anything it doesn’t need to continue its operations. It gave away $109 billion last year, and just $90 billion in 2020.

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

It is currently paying more interest than it is receiving from its bond holdings and other income sources. As it tightens monetary policies, the loss will only increase. Meanwhile, it’s also seeking to shrink the size of its balance sheet, which means reduced interest income from securities.

The Fed’s deferred asset to cover its loss is similar to an IOU to government. The Fed believes that the deferred asset will be paid down and that it will cover the loss when it returns to profitability. Officials have been adamant that losing money does not affect the Fed’s ability to operate.

POLITICAL FRICTION

Fed experts however warn that some political leaders could in the future question the loss, especially as it is being driven by a monetary policy toolkit that’s paying banks to park cash. Many of these foreign banks are being used by the Fed, which could lead to questions about why they are helping banks while making credit more expensive for ordinary Americans.

English noted that Fed operational losses are “not a significant economic issue” but the political side of the equation could become a flash point.

In a June paper, he and former Fed second-in command Donald Kohn discussed the potential danger of a flash point in a deficit. The Fed’s history of distributing money to reduce deficits has been touted over the years. In the event that those funds disappear, it could be a problem.

The Fed’s current income situation is however unique. It has been giving back cash to the government, as required by law, for many years. Instead of building up a nest fund that it could draw on if income turns negative, it has been doing this for many years. Some believe Congress will recall this arrangement before they pursue the central bank.

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

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Stocksak Editorial

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