The Fed is in the red: Should it still pay CFPB’s bills?

Published in The Hill with Paul Kupiec.

The Fifth Circuit Court of Appeals just ruled that the Dodd-Frank Act’s requirement that the Federal Reserve pays the expenses of the Consumer Financial Protection Bureau is unconstitutional. This important ruling adds to another problematic aspect of the CFPB’s funding scheme — the Federal Reserve no longer has enough earnings to cover the $692 million in checks the CFBP writes each year.

The CFPB’s 2022 “Budget Overview” states that “The CFPB’s operations are funded principally by transfers … from the combined earnings of the Federal Reserve.” But in the fall of 2022, this is not true. There are no such earnings, the Fed is losing money. Making the Fed pay the CFPB’s expenses simply makes those losses larger. It also keeps the CFPB’s expenses out of the federal budget deficit where the court ruling says they rightly belong.

Former Fed Chairman Ben Bernanke has just been awarded the Nobel Prize in economics, but the policy of quantitative easing he championed has left the Fed with market value losses of monumental proportions. We estimate that the Fed’s balance sheet as of mid-October suffers from a $1.3 trillion mark-to-market loss. That is 30 times the Fed’s total capital of $42 billion. To put the size of this loss in perspective, it is nearly equal to Spain’s GDP and larger than the GDP of Indonesia.

The Fed says these mark-to-market losses are not an issue, they are “merely” unrealized losses. It does not include them in the asset valuations or the capital it reports on its financial statements. Since the Fed does not intend to sell any of its underwater investments, it says there is no danger it will experience a cash loss. While the Fed can feign indifference to a $1.3 trillion market value loss on its investment portfolio, imagine your reaction if you opened your 401(k) statement and saw a very large unrealized loss. 

As short-term interest rates increase, the Fed is experiencing both unrealized mark-to-market losses and cash operating losses. Both will continue because of the Fed’s massive interest rate mismatch. The Fed’s investment portfolio has a net position of about $5 trillion of long-term fixed-rate investments, much of them with remaining maturities of more than 10 years. These investments are funded with floating rate liabilities. The Fed is the financial equivalent of a $5 trillion 1980s-vintage savings and loan. When short-term interest rates rise, its profits naturally shrink and then turn into losses.

We estimate that, in round numbers, for each 1 percent that short-term interest rates increase, the Fed’s annual net income falls by $50 billion. Since the interest rate on the Fed’s floating rate liabilities has increased by 3 percent (so far) in 2022, the Fed is now posting substantial losses and will continue to post losses going forward.

In May, we estimated that the Fed would begin losing money when short-term rates exceed 2.7 percent. With the last FOMC rate increase, the Fed is now paying about 3.1 percent on bank reserve balances so the Fed’s operating profits should already be in the red. A comparison of the Fed’s Oct. 19, H.4.1 Report with its report from mid-September shows that, over the past month, the Fed has accumulated an operating loss of about $5 billion. The loss appears in Table 6 in the account, “Earnings remittances due to the U.S. Treasury.” On Oct. 19, the account is negative, which means the Fed is now losing money.

A loss of $5 billion in a month annualizes to a loss of $60 billion. At current short-term interest rates, not only are there no Fed profits to cover the checks CFPB will be writing, but the Fed’s annual operating loss is on a path that will soon exceed the Fed’s total capital. If these operating losses were booked into retained earnings, as required by Generally Accepted Accounting Principles, within a year, the Fed would report negative capital. In other words, using normal accounting standards, the Fed will soon be technically insolvent.

But unlike the banks it regulates, the Fed will not report negative capital and it won’t go out of business as its losses continue to accumulate. In its accounting statements, the Fed will offset operating losses dollar-for-dollar by debiting an intangible (better said, an imaginary) asset account called a “deferred asset.” As long as the Fed has a deferred asset balance, which may be for years, it will make no payments to the Treasury. In the meantime, the Fed will print money to pay its bills, further contributing to inflation.

If interest rates continue to increase, as nearly everyone expects, Fed losses will grow. The Fed’s total cash losses could easily grow to $100 billion or more over time — maybe a lot more — before rates decline. Ironically, the more the Fed fights inflation by increasing short-term interest rates, the bigger its own loss becomes.

From its inception in 1913, the Fed has been structured to make profits from its money printing monopoly and required to send most of its profits to the Treasury to reduce the federal deficit. But today the Fed’s short-funded quantitative easing investments have resulted in losses that exceed its seigniorage profits.

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Accounted for properly, Fed losses increase the federal deficit that ultimately must be paid by future taxes — but Fed losses are currently not counted in federal deficit estimates. As the next Congress considers Fed reforms, it should also require that Fed operating losses also be included in the federal budget deficit.

While the CFPB’s expenses are clearly federal government expenditures, they are currently not counted in the federal budget and have hitherto been set by an unelected CFPB director and evaded congressional appropriations by making the Fed pay the CFPB’s bills. If the Fifth Circuit’s ruling prevails, these expenditures could be put into a normal democratic process, set by the elected representatives of the people in a constitutional fashion, and no longer be increasing the Federal Reserve’s already embarrassingly large losses.

Alex J. Pollock is the co-author of the newly published “Surprised Again!—The Covid Crisis and the New Market Bubble,” and a senior fellow at the Mises Institute.  Paul Kupiec is a senior fellow at the American Enterprise Institute.