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Why the Fed is losing billions every week & its implications
The US Federal Reserve is losing billions of dollars every week. Yes, you read that right. BILLIONS. How did the Fed get into this position, and what does it mean for the future of monetary policy and the United States (US) at large?
UPDATE - whilst not clearly explained by the Fed, please note that the Fed’s weekly remittances data has turned cumulative once the Fed began to generate operating losses - the below chart shows weekly remittances adjusted to reflect the change in the cumulative negative number.
The era of QE
In order to answer these questions, we first need to jump back in time to the GFC. It was here that the Fed implemented the first round of its Quantitative Easing (QE) program. QE1 as it became to be known (so as to distinguish from the Fed’s later, but separate QE programs), was launched on 25 November 2008. The program was later expanded from its initial $600bn starting point, and spawned several follow-up QE programs. The result of these programs was a massive increase in the size of the Fed’s balance sheet.
By the time QE3 ended in 2014, the Fed’s balance sheet had grown from under $1tn to $4.5tn. The Federal Reserve, under current Chairman Jerome Powell, begun a process of unwinding its balance sheet in 2017, which explains the tapering of its total asset balance from $4.5tn, to a trough of $3.8tn in August 2019.
The Fed stopped its tapering program in September 2019, highlighting how US monetary policy has changed to a regime of huge excess reserves. Shortly after ending this moderate scale back of its balance sheet, the repo market began experiencing turmoil, which required the Fed to once again increase liquidity and the size of its balance sheet.
Shortly after this had occurred, the COVID-19 pandemic began to spread fear throughout the world. Governments began instituting broad dictates that many had previously thought unimaginable. After seeing the images and news reports of strict lockdowns in China, people broadly scoffed and oft repeated that such methods wouldn’t ever be used in their own “free” countries, only to soon begin clamoring for their own governments to institute similarly aggressive dictates. The impact this had on the economy, was, of course, enormous. The Fed responded by yet again conducting QE, drastically increasing the size of its balance sheet. The previous $4.5tn peak was surged past in March 2020, with the Fed’s balance sheet topping out at $8.9tn in April 2022, on an end of month basis.
The Fed’s current tapering of its balance sheet, which started in June 2022, can be seen in the very modest decline of the Fed’s total assets from peak levels.
The creation of huge reserve balances & interest payments
While the Fed’s QE programs explain its larger balance sheet, this is only the first part of the puzzle that must be unraveled in order to explain its now large operating losses. When the Fed purchases assets like Treasury securities through the operation of its QE programs, the Fed purchases them in the secondary market. In exchange for the Treasury securities, the Fed hands over dollars in the form of reserves. Given the unique nature of the Fed, these reserves appear at the press of a button — the Fed simply ‘prints’ the amount of money required to satisfy its intended asset purchases. This huge increase in its balance sheet has thus resulted in a very large increase to reserve balances.
Historically banks were required to hold a minimum level of reserves in relation to their deposits. Reserves held above this level were termed excess reserves. Ordinarily, banks looked to minimise excess reserves as they did not earn interest. Instead of having cash that wasn’t legally mandated to sit idle at the Fed, banks historically ensured that they maximised their lending in order to maximise their returns. Excess reserves were thus largely non-existent before the GFC.
The huge expansion of the Fed’s balance sheet completely changed the narrative, so much so that the Fed removed reserve requirements in 2020, with reserve balances so high, that the Fed has entered a different era of central baking, which the Fed terms as an “ample reserves regime”.
The implications of ample reserves for monetary policy
Such huge levels of reserves create two complications for monetary policy.
The first thing to remember is that banks generally do not want to have large levels of excess reserves, as they can increase their returns by lending them out. This can create problems when ample reserves exist, as banks now have an incentive to drastically increase their loans to increase returns. If banks did drastically increase their loans, this would result in potentially extreme increases in the M2 money supply, and inflation. Though it is important to note that whilst reserve requirements no longer constrain lending, banks are still subject to capital ratio requirements. Further still, even with large excess reserves, adequate demand from sufficiently creditworthy borrowers also places a constraint on the level of loans that are made — banks won’t simply start handing out money willy nilly because of excess reserves, as the key is the risk-adjusted return they can make, not simply the extra returns that could be made.
The second key implication, and one that is extremely important, is that the Fed traditionally achieved its federal funds rate target by altering the level of reserves. In order to tighten rates, the Fed would take reserves out of the system by shrinking its balance sheet. In order to lower rates, the Fed would increase reserves by increasing the size of its balance sheet. Given that excess reserves were generally minimal, the Fed could achieve this with relatively small interventions. This method of interest rate targeting is no longer applicable under an ample reserves framework. If the Fed continued to conduct monetary policy in such a manner, with such high levels of excess reserves, short-term rates would be driven down to effectively zero - no matter what its federal funds rate target was set at. The only way to have avoided this outcome would have been to MASSIVELY shrink the level of reserves in the system - something that would cause major issues to the plumbing of the US financial system, which has grown dependent upon high levels of reserves.
In order to counteract these issues, in 2008, Congress authorised the Federal Reserve to pay interest on reserve balances that banks hold at the Fed. By paying interest on reserve balances, this puts a floor on overnight lending rates, as banks have no incentive to lend to private counterparties at a rate below that which they can generate a risk-free return by maintaining reserve balances at the Fed.
In order to implement its federal funds rate target since the GFC, the Fed has thus moved the interest rate that it pays on reserves in-line with its federal funds rate target. By generating a risk-free return in-line with the federal funds rate, banks also have a lesser incentive to loan out their excess reserves, further reducing the potential for there to be being explosive growth in M2 and inflation.
An ample reserves regime generates large operating profits/losses
After having explained the changes that have occurred in the size of the Fed’s balance sheet, and the direct impact this has on the level of reserves that are held at the Fed, one can understand why the Fed now generates significant operating gains and losses.
On the income side of the equation is the interest received by the Fed from its large holdings of Treasuries and mortgage-backed securities (MBSs). On the expense side is the interest that the Fed pays to banks on reserves that they hold at the Fed.
ZIRP meant that the ample reserves regime was historically very profitable
With the Fed maintaining a zero interest rate policy (ZIRP) for the majority of the time since the GFC, the expansion of its balance sheet has generally been a very lucrative business. This is because the interest it paid on reserves held at the Fed was much lower than the interest it earned on its portfolio of Treasuries and MBSs. The chart below shows the spread between the monthly average 10-year Treasury yield, and the interest the Fed pays on reserves. While the Fed also holds shorter-term Treasuries, and MBSs, the point nevertheless holds that the spread between the rate of interest earned on its assets versus the interest paid on reserves, was generally large enough that the Fed made SIGNIFICANT profits.
Just how profitable was it? From 2011-2021, the average annual remittance that the Fed made to the US Treasury as a result of its positive earnings was $83.5bn. Profits peaked in 2021 on the combination of 1) a huge increase in the Fed’s balance sheet that resulted in higher interest income, and 2) a return to ZIRP as the Fed implemented policies to respond to the COVID pandemic. Note also how the Fed’s profits saw YoY declines across 2016-19. This occurred as a result of the Fed’s earnings being impacted by a rising federal funds rate, which necessitated an increase in the interest rate paid on reserves.
Actions during COVID sowed the seeds of the Fed’s current losses
While the monetary policy responses that stemmed from the COVID pandemic initially brought about the Fed’s highest profits, it also sowed the seeds for the Fed’s current operating losses. Two key things contributed to this:
1) The Fed’s ~$4.8tn in asset purchases & ZIRP in response to COVID meant that it purchased huge quantities of bonds at historically very low yields.
2) The Federal Government undertook HUGE deficit spending in response to the COVID pandemic, which exceeded 15% of GDP in 2020.
The added element of the extreme federal government deficits, meant that instead of money remaining on the sidelines of the real economy as reserves at the Fed, this time it found its way into the real economy - and it didn’t just quietly trickle in, it FLOODED in. The annual average increase in M2 during 2020 was the second highest EVER recorded in the US’ post-Civil War history, with higher growth only seen during WWII.
The highest M2 growth since WWII created high inflation & a huge hit to the Fed’s net operating position
The extreme artificial influx of new money into the economy led to a major problem — high inflation. This flipped the script on four decades of relatively low inflation. It also flipped the script on the Fed’s net operating position. For over a decade it was able to earn huge profits as interest payments on reserves held at the Fed were minimised on account of the Fed keeping interest rates artificially low. With inflation surging, the Fed could no longer maintain ZIRP.
Higher inflation lead to the Fed drastically increasing the federal funds rate. In order to effect this change, it had to commensurately raise the interest rate on reserve balances (IORB). Not only did the interest rate rise, but recall also that the level of reserves in the system had significantly increased as a result of the Fed’s QE operations throughout COVID.
Meanwhile, the Fed’s interest income remains fixed at the level that was commensurate with its prior asset purchases — trillions of which were purchased during the ultra-low rates that were on offer during COVID.
Put all of this together, and suddenly you get what looks like a particularly nasty outcome for the Fed, being HUGE losses. The higher the Fed’s interest rate rises, the bigger its losses will get, as this increases the IORB.
With the Fed aggressively raising interest rates over recent months, huge losses are exactly what have begun to eventuate. Weekly earnings first turned negative in September 2022. Whilst the Fed’s data suggests that losses have risen to $10.6bn in the week to 23 November, it appears that once remittances turned negative, this dataset has become a cumulative number (though this has not been well articulated by the Fed). So whilst the losses aren’t as large as what seems to be the case on face value, this is nevertheless a drastic turnaround from the weekly profits of well above $3bn that were being recorded just six months earlier.
The implications of these losses within the broader environment
The first thing to realise is that unlike an ordinary individual or corporation, the Federal Reserve cannot go broke, no matter how large its losses get. Why? Money may not grow on trees, but the Fed’s got an even better system — growing it at the press of a button.
Now some of you may be thinking, printing money!? Isn’t that inflationary and incredibly counterintuitive during a time of high inflation? During a time at which the Fed is actively trying to lower inflation?
While this may look to be the case, when the current situation is looked at more broadly, it becomes clear that the current environment being fostered by the Fed remains disinflationary. Let’s breakdown why.
Firstly, the rolling 12-month federal government deficit has shrunk significantly from the extreme levels seen following COVID, back towards its historical pre-COVID level. This follows revenue benefits that have stemmed from inflation, and lower COVID related expenses.
The Fed has also significantly raised interest rates since March, and begun another round of quantitative tightening (QT) in June. The combination of these factors has resulted in the US seeing the largest deceleration in the YoY growth rate of its M2 money supply in at least 60+ years (as far back as the Fed provides monthly M2 data). This is the single most important determinator of future inflation, and it continues to SCREAM that inflation will fall drastically over the year ahead.
Also whilst the Fed is recording operating losses, they are smaller than the current rate of QT that the Fed is currently conducting — which is currently running at a scheduled monthly taper of $95bn per month. While settlement timing is something that impacts the actual figures delivered, the Fed’s total assets have been declining since May.
So whilst the Fed’s operating losses put pressure on reserves to rise, the net impact of all of its current policies, namely being a continued reduction in its total assets, is a continued reduction in reserve balances. The wash out of this is that while the optics are bad, the Fed’s current level of operating losses are not sufficiently high enough to warrant concern about near-term inflationary ramifications.
To further reinforce this point, and to understand the totality of current conditions, look at the recent MoM changes in M2 - it’s been DECLINING! So what is already one of the greatest ever decelerations in the YoY growth rate of M2, is continuing to further decelerate, with a YoY decline likely to imminently occur for the first time in at least 60+ years!
What does this whole scenario say about the state of the US economy and its financial system?
Whilst the current level of the Fed’s operating losses are not having any immediate major ramifications for the conduct of monetary policy or the US economy, they nevertheless signal serious long-term, structural problems.
The extended periods of ZIRP and QE have created an economy that has become increasingly addicted and leveraged to debt — this is true of both the government and corporate sectors, where debt as a percentage of GDP has ballooned over recent decades.
The highly unorthodox monetary policy that currently exists, which includes a very high level of reserves, is a symptom of the structural problems that are present as a result of too much debt. It is also important to note that this is true not just for the US, but much of the wider world’s national economies — the allure of leveraging economic growth via debt is difficult for many nations to resist.
Eventually the continuation of an inflationary monetary system, and the continued build up of debt, will reach a tipping point. A point whereby debt levels are so high, that people begin to lose trust in the ability of even major governments to service, let alone fully repay, their debts.
How can the underlying problems be fixed and is the US moving in the direction of fixing them?
In order to avoid such an outcome, the federal government needs to rein in its spending and return to a budget surplus. The Federal Reserve needs to avoid keeping interest rates artificially low, and needs to eliminate the huge levels of reserves from its balance sheet.
Interestingly, the Fed is currently doing what is required. Unfortunately, the federal government continues to spend with as much restraint as a drunken sailor.
Given that the Fed is both raising interest rates and reducing the size of its balance sheet, it is promoting significant debt deleveraging, which is EXACTLY what is needed in order to alleviate the major long-term problems that stem from too much debt.
The process by which higher interest rates promote economic deleveraging is simple — when the cost of something rises, demand will fall. When the cost of borrowing is higher, the demand for borrowing, all else equal, will fall.
The problem is, such a process is painful — remember how the Fed ended its earlier bout of QT in 2019, after only a modest runoff of its balance sheet. There is a reason that the money supply rarely contracts in an inflationary, fractional reserve banking system. There is a reason that debt usually expands — it leads to bigger returns. The deleveraging process exposes the house of cards. Economic activity will contract, firms will fail, people will lose their jobs, and cracks will form in the financial system.
So whilst the Fed’s current actions will result in debt deleveraging, the Fed’s continued tightening in the face of an already declining M2 money supply makes a severe recession increasingly likely. Given the enormous pain that this would entail, the Fed is once again likely to re-adopt ZIRP & QE — particularly given that as opposed to high inflation, deflation has a very significant chance of occurring once the economy begins to materially contract amidst falling M2.
Meanwhile, at the same time as the Fed’s tightening promotes debt deleveraging, the federal government continues its spending binge. Continued large deficits amidst rising interest rates have created a surging federal government interest expense.
Note that the current spike in the US Federal Government’s interest expense has occurred alongside only a moderate increase in its average interest rate (equal to 2.2% in October), which remains well below the current federal funds rate target of 3.75-4.00%, and the current trading range of government bond yields.
If the Fed held interest rates at current levels, and the US government’s gross federal debt was eventually all refinanced at the current effective federal funds rate of 3.83%, the US government’s current $31.3tn gross debt would equal an annual interest bill of $1.2tn. On FY22 spending, this would mean that only spending on Health and Human Services ($1.6tn), and Social Security Administration ($1.3tn) would be larger than the US government’s interest bill. The interest bill would also be equal to 24.5% of the US government’s total receipts. Furthermore, this also doesn’t account for the fact that the federal goverment’s debt continues to grow and grow, which will further increase the future interest burden.
With the federal government continuing to spend recklessly, higher interest rates are serving to further INCREASE the federal government’s outlays, which increases the pace at which its gross debt rises, which acts to bring forward the point at which a tipping point is reached.
In order for the US to effectively deleverage, the Fed’s current tightening MUST be combined with a responsible federal budget that begins to REDUCE its outstanding debt. Without this, the US CANNOT return to a long-term pathway that is sustainable.
While unfortunate for the US’ long-term prosperity, a responsible federal budget is unlikely to be seen anytime soon, as this will only compound the short-term damage of a painful debt deleveraging that is currently being encouraged by the Fed. With politicians worried about the next election, and the more severe consequences of continued debt and deficits likely to be felt when somebody else is in charge, a move to sustainable levels of spending in Washington continues to look extremely unlikely in the near-term.
What happens if the current unsustainable pathway is continued?
Should the US Federal Government continue to accumulate more and more debt, a tipping point will eventually be reached, whereby individuals have a significantly reduced confidence to invest in government securities, significantly raising free market interest rates on government debt.
Once this tipping point is reached, history has shown that governments generally take one way out — inflation. While such a crisis is likely to result in a greater political will to return to a sustainable budget path, history shows that by this stage, the damage of debt deleveraging is often more painful than the alternative of hyperinflation. When debt reaches levels that become too burdensome to service, much less repay, inflation is thus time and time again chosen as the solution. There are many examples of this playing out throughout history and across civilisations. Think about this too at an individual level — once one becomes very heavily indebeted, bankruptcy is often an easier alternative than a protracted decline in consumption to eliminate the debt.
In order to continue paying its debts without conducting a painful debt deleveraging, the Fed will increase its government bond buying by larger and larger amounts. The outcome of such a process is eventually hyperinflation.
Once inflation reaches very high levels, the accumulated tens of trillions of dollars in debt is no longer very large in real terms. Creditors can thus be easily repaid without having to officially declare default, although a practical default is exactly what the creditors will feel as having occurred.
Eventually, a new currency is issued to replace the old one, and hopefully a prosperous period follows, as the economic pain that came from too much debt remains in the minds of individuals for decades to come. A nation who experiences such high inflation is thus more likely to rebuild upon a strong foundation of budget surpluses, savings and living within one’s means.
Is there time for the US to return to a sustainable path?
Today the US remains as the world’s preeminent power, giving it time to return to a budgetary pathway that would encourage long-term strength. Though with other nations rising, the budgetary and geopolitical decisions it makes over the next decade are likely to prove critical in determining how much longer the US has to return to a sound fiscal position.
The federal government’s current spending appetite is particularly dangerous in light of the Fed’s tightening causing a decline in M2, as in the event that this does cause a severe recession, the federal government is likely to respond with MAJOR stimulus spending. This would drastically narrow the window that the US has to return to a sustainable footing, just as the enormous spending in the wake of the COVID pandemic did.
Ultimately, the greater the number of individuals that realise the precarious long-term footing of the US’ financial position, and how important it is for individuals, businesses, and governments to reduce their debt levels, the greater the likelihood that the US continues as a leading nation for many years to come. The greater the number of individuals that instead demand continued spending, debt and deficits, as well as an aggressive foreign policy, the closer and closer the US will venture towards a very dangerous precipice.
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What do you think the odds are that the US returns to a sustainable economic footing, led by a return to federal government budget surpluses? Let me know in the comments below!
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