For the First Time, the Fed Is Losing Money

Published in The Wall Street Journal with Paul H. Kupiec.

Thanks to interest-rate risk exposure, the central bank will soon have negative equity capital.

Like all central banks, the Federal Reserve was designed to make money for the government from its monopoly on issuing currency. The Fed did generate profits, which it sent to the Treasury, every year from 1916 on—until last fall. In a development previously unheard of, the Federal Reserve has suffered operating losses of about $42 billion since September 2022.

That month, the massive interest-rate risk created by the Fed’s asset-liability maturity mismatch began generating cash-operating losses, and the losses now average $7 billion a month. This is because the Fed’s trillions of dollars of long-term investments yield 2% but cost 4.6% to finance. The Fed will soon have negative equity capital, and as operating losses continue to mount, its equity-capital deficit will grow.

In a July 15, 2022, note, the Fed’s Board of Governors discussed the possibility that the system could incur substantial operating losses as it increased interest rates to fight inflation. The Fed tried to play down the importance of the issue, arguing that its “mandate is neither to make profits nor to avoid losses”—a deflection that is disappointingly transparent to anyone familiar with central banking.

The Fed traditionally avoided policies that would expose it to significant losses. In the early years, member banks could borrow from reserve banks only by posting specific collateral. The Federal Reserve Act required loans to be backed by qualifying short-term self-liquidating bills—what today we call commercial paper. Over time, loan collateral requirements evolved, but as they did, the Fed introduced policies to protect it from losses when lending to member banks.

When Congress or the executive branch tapped the Fed for emergency loans to avert a wider financial crisis, it sought government guarantees to protect itself from default losses. Franklin D. Roosevelt’s administration asked the Fed to stand ready to provide loans to banks that were allowed to reopen after the 1933 national bank holiday. Instead of lending directly to these banks, the Fed proposed that it lend to the Reconstruction Finance Corp., which could then lend the proceeds to the newly reopened banks—because the RFC had an explicit federal-government guarantee that would protect the Federal Reserve system from potential losses should a newly reopened bank fail.

Similarly, the Fed’s special lending programs in response to the 2008 and 2020 financial crises were undertaken only after the Treasury allocated funds to absorb losses the Fed might incur from emergency loans. The latest Fed special lending facility, announced on March 12, also protects the Fed from lending losses. The first $25 billion of losses incurred by this new emergency program (which lends banks the par value of their underwater mortgage-backed securities and Treasurys) will be covered by the Treasury.

Avoiding credit losses is a requirement Congress added to the Federal Reserve Act in 2010. Section 1101 of the Dodd-Frank Act requires the Federal Reserve Board to establish “policies and procedures . . . designed to ensure that any emergency lending program or facility . . . protect taxpayers from losses.” Federal reserve banks are also mandated to assign “a lendable value to all collateral for a loan executed by a Federal reserve bank . . . in determining whether the loan is secured satisfactorily.”

While the Federal Reserve Act requires the Fed to avoid taking credit related losses that could have an impact on taxpayers, it makes no mention of losses from interest-rate risk exposures. The act’s authors never imagined such losses. Monetary policy was all but assured to generate Fed profits prior to 2008. That changed once the Fed started paying banks interest on their reserve balances and making large open market purchases of long-maturity Treasurys and mortgage-backed securities.

Fed losses from its interest-rate-risk exposures—unrecognized taxpayer losses—are now being realized in ways Congress never intended and at magnitudes neither the Congress nor the Fed ever expected.

Mr. Kupiec is a senior fellow at the American Enterprise Institute. Mr. Pollock is a senior fellow at the Mises Institute and a co-author of “Surprised Again! The Covid Crisis and the New Market Bubble.”