I recently participated in a conference where I learned that my colleague, Alex Pollock, had testified to Congress in September on ways to reform the Fed. You can read Alex’s testimony for yourself to get his position on the Fed’s mandates, but here on the infineo blog I wanted to relay his statements about Fed insolvency, as this is a topic I’ve been covering.
Specifically, as of the Fed’s most recent report, it is running a cumulative $243 billion operating loss. This is distinct from its nearly $1 trillion unrealized losses (in a mark-to-market sense) on its portfolio. Because the Fed’s equity position (the capital paid in by its member banks, which are the actual shareholders of the Federal Reserve banks) of some $46 billion is much smaller than even the operating loss (let alone the unrealized loss), the Fed is quite literally insolvent—or “bankrupt” in the colloquial sense.
Now to be sure, just because the Fed’s liabilities are higher than its assets, doesn’t mean it has to shut its doors. Chairman Powell isn’t going anywhere, and nobody is calling the police to arrest him for fraud. But this is because the Federal Reserve has the legal ability to create official US money; the Fed is technically insolvent in a way that would make any other business—even any other bank—have to shut down.
How did this happen? The big picture is that, after the financial crisis and then again when Covid struck, the Fed slashed interest rates while loading up on trillions worth of fixed-income assets, namely Treasuries and mortgage-backed securities. When consumer price inflation began ripping in 2021 and 2022, the Fed began aggressively raising interest rates.
The problem for the Fed was twofold: In terms of market value, their assets plummeted with higher interest rates; the price of a bond drops when interest rates rise. This explains the nearly trillion dollar “paper loss” that the Fed has suffered because of the shift upward in the yield curve.
But beyond the “paper loss” that one might think was acceptable so long as the bond is held to maturity, was the problem of expense versus income. To a first approximation, the Fed had to pay 4 percent on deposits to hold their portfolio that was only earning 2 percent. Even though the Fed can “create money out of thin air,” it nonetheless pays interest on the reserves that banks keep parked at the Fed. (This was a policy innovation begun in October 2008; prior to then, the Fed didn’t pay interest to banks for keeping reserves at the Fed.) This is where the cumulative $243 billion operating loss came from.
Finally, let me mention that it seems Fed officials were aware of this problem, back during the initial rounds of QE when they first began inflating the balance sheet. As I noted in an article in February 2011, in the previous month the Fed had made—what seemed to be—an innocuous announcement about an accounting change, that actually had massive implications.
To understand the accounting trick, you first need context: Normally, when the Fed earns a profit during the period, it pays its bills (including dividends on capital to the member banks which own it), and then “remits” the excess earnings to the Treasury. Thus, in normal times, the Fed helps reduce the federal budget deficit.
But with the new accounting trick announced in early 2011, in a situation in which the Fed had an operating loss—if such a thing should ever happen—then it would be shown on the Liabilities side of the balance sheet, as a “negative liability” owed to the Treasury. Then, over time, as the Fed earned profits, it would whittle down (up?) this negative liability back towards $0.
By this clever move, the Fed would not have to mark down its assets, which would make the shareholder equity become negative. In other words, the trick of reporting a “negative liability” would take the Fed’s insolvency and move it somewhere else on the balance sheet.
Back in 2011, those of us pointing out this implication were dismissed by some as conspiracy theorists. But events have vindicated our warnings, which leads me to suspect that Fed officials back during the early rounds of QE knew full well the genie they were letting out of the bottle.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.
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