Monday, April 15, 2024

Federal Reserve Operating Losses and Monetary Policy

Without inquiring too deeply into the matter I had just assumed the Fed would create the money it needed. It looks like there may be more to the story.

From The American Enterprise Institute, January 1, 2024:

Past monetary policy decisions have resulted in the Fed suffering more than $140 billion in accumulated cash losses in addition to $1 trillion in unrealized losses on its securities portfolio. The Fed System and the majority of Reserve Banks are technically insolvent on a GAAP basis. Fed officials claim that the Fed’s losses and negative GAAP capital do not compromise its ability to conduct monetary policy because the Fed can create money to cover its losses, however large the losses may become. The Fed’s narrative leaves out important details including that the Fed’s ability to print paper currency is limited by law and deposits held at insolvent Reserve Banks are unsecured liabilities that are legally at risk because they lack a federal government guarantee. We calculate the GAAP capital of each Reserve Bank and the System, and estimate depositors’ loss exposures under current law. We review the current legal framework in place for addressing insolvent Reserve Banks. We conclude that the framework will be ignored, and the Fed will continue to operate at a loss while deeply technically insolvent as long as depositors maintain their belief that Fed deposits are protected by an implicit federal government guarantee. Congressional action may be needed should this confidence waver.
1. Introduction
Many people believe that the Federal Reserve’s ability to conduct monetary policy will not be affected by its huge and growing cash operating losses and the massive unrealized mark-to-market losses on its securities portfolio.3 Confidence in the Fed’s ability to operate normally despite massive losses is rooted in the presumption that the Fed has unlimited power to create whatever amount of money is needed to pay its bills. Naturally, the Federal Reserve itself promotes such beliefs, but as we explain in this paper, these claims are not consistent with current law. The Fed does not have unlimited authority to print Federal Reserve Notes or borrow using reverse repurchase agreements. Moreover, as losses accumulate there is a growing risk that depositors’ risk perceptions will intervene and impact the Fed’s ability to fund its growing losses with FRB deposits. 

The belief that the Federal Reserve’s monetary policy operations are unaffected by its extraordinarily large and continuing losses reflects claims made by current and former Federal Reserve Board senior officials. Consider, for example, statements made in a June 2022 Brookings Institution Commentary by former Federal Reserve Vice-Chairman Donald Kohn and William English, the former Director of the Board of Governors Division of Monetary Affairs and Secretary to the Federal Open Market Committee. In their commentary, Kohn and English write [bold in original],

Would those [Fed] losses have any implication for the Fed’s ability to make monetary policy? No. Despite any plausible losses, the Fed could continue to operate normally and implement monetary policy.

But couldn’t Fed losses lead it to default in some way, causing a financial crisis or high inflation? The Fed can’t default because it can always create reserves to pay its bills. Moreover, the banking sector must hold the reserves created by the Fed, so the Fed cannot suffer a run on its funding.
In his June 2023 semi-annual testimony on monetary policy in the Senate, Chairman Powell’s response to Senator Tim Scott’s question about the implications of the Fed’s cash operating and mark-to-market portfolio losses repeated claims made by Kohn and English,4
Remember that the way it works at the Fed is, when we buy assets in QE, we pay for them with overnight interest rate reserves, and we, for many many years in the QE era, we have earned a spread and been sending money to the Treasury, well over a trillion dollars, since QE started. So now that rates have gone back up to 5 percent, that process has reversed, and these are paper losses, they have absolutely no effect on our ability to conduct monetary policy, or really on the economy, it just an accounting effect. If we retained capital, that would be, look completely different, but we give all of our profits to the Treasury.

The Fed’s narrative concerning its embarrassing and unprecedented losses, while politically expedient, lacks some very important qualifications. First of all, the Federal Reserve System’s $139 billion of accumulated operating losses are not just “paper” losses or an “accounting effect”, but actual cash losses. At current interest rates, Fed losses continue to grow by more than $2 billion each week.

We show that accumulating operating losses have already caused 8 of the 12 Federal Reserve Banks (FRBs) to have liabilities that exceed the book value of their real assets. The excess of FRBs’ liabilities over the value of FRBs’ assets is $1 trillion greater if one accounts for the mark-to-market losses on the Federal Reserve System’s Open Market Account (SOMA) fixed income assets. Using the current market value for FRBs’ assets, the excess of liabilities over assets is huge for all 12 FRBs. 

The Federal Reserve Board has the regulatory power to intervene and take control of FRBs, including suspending FRB operations, exercising FRB member bank capital and loss sharing contingent obligations, or even liquidating FRBs, but we do not expect the Federal Reserve Board to take any corrective actions. As FRBs’ financial conditions continue to deteriorate, however, some FRB depositors might take actions to limit their FRB deposit exposures.

It is true that the Fed can operate at a loss while deeply technically insolvent and still continue to pay banks billions in interest and dividend payments, but only as long as the public and financial market participants retain confidence in the Fed’s ability to honor its unsecured liabilities. But as losses continue to grow, any support FRBs’ unsecured depositors gain from the value of FRBs’ unpledged assets will be eroded as FRBs issue additional Federal Reserve Notes and reverse repurchase agreements to fund their operations. Unless FRB depositors believe that their FRB deposits are ultimately guaranteed by the federal government (they legally are not), at some point, as rational investors, they will demand a risk premium for holding balances at FRBs. Should that happen, monetary policy will become even more expensive for the Fed and ultimately for taxpayers.

We explain in detail how, if current laws are enforced, accumulating Federal Reserve System losses should cause rational depositors to question whether their deposits in the 12 FRBs are unconditionally safe and liquid. The loss of FRB depositor confidence, or even the remote risk that depositors might lose confidence, would adversely impact the Fed’s ability to implement monetary policy and possibly require Congressional intervention.

FRB depositors in the aggregate cannot run in the way they might if they held uninsured deposits in a deeply technically insolvent commercial bank. Instead, risk sensitive FRB depositors would likely try to substitute fully collateralized or federally guaranteed claims for their excess FRB deposit balances. Such a shift could require the Fed to either sell SOMA securities at a loss to keep short term risk-free yields from declining below the Fed’s target rate, or to pay FRB depositors a risk premium over the Fed’s target policy rate to retain FRB deposit balances. Such a shift in FRB deposit demand would raise the Fed’s cost of maintaining a desired policy rate and further exacerbate FRB operating losses and FRB collateral shortfalls.....

....MUCH MORE (22 page PDF)