The losses of the US Federal Reserve have surpassed the $100 billion level and are certain to rise significantly before the bleeding stops, according to the latest data from the institution.

The U.S. central bank is still losing money on interest expenses compared to what it is bringing in from the interest it receives on the bonds it holds and from the services it offers to the financial industry. Although there is a great deal of uncertainty on how it will all turn out, some experts think that Fed losses, which started a year ago, may eventually increase by as much as double before decreasing.

Yale University professor William English, a former senior central bank employee, predicted a “peak” loss of over $200 billion by 2025.

Derek Tang, a forecaster at LH Meyer, stated that the loss will probably be between $150 billion and $200 billion by the next year.

The Fed records its losses as what it refers to as a deferred asset, an accounting metric that counts what it will ultimately need to pay before it can resume its customary practise of returning its earnings to the Treasury. Losses are quite uncommon for the Fed. The central bank has repeatedly emphasised that the situation does not in any way affect its ability to implement monetary policy and to accomplish its objectives.

It was a costly mistake Given its vigorous push to raise interest rates—which has brought the benchmark overnight interest rate from near-zero in March 2022 to its current range of 5.25%–5.50%—the Fed has not come as a surprise. It is generally believed that the Fed has finished raising rates, or is very close to doing so, as inflationary pressures are subsiding.

However, it doesn’t follow that the losses will stop growing because the current short-term interest rate environment will keep the net negative income rising for a while. Instead, the Fed’s continued process of reducing its balance sheet, which complements its rate hikes, will eventually cause the losses to end.

During the coronavirus outbreak and its early aftermath, the Fed actively purchased bonds. In the little more than a year since then, it has sold off about $1 trillion in Treasury and mortgage bonds. According to Fed officials, more needs to be done on this front, and as a result, the central bank will have to pay less in interest because it is draining the banking system of liquidity. Markets for financial instruments anticipate a halt in the second or third quarter of 2024.

Bank reserves and deposits into the central bank’s reverse repo facility are the two main sources of the liquidity that the Fed is targeting.

Through these instruments, the Fed pays a variety of banks, money managers, and other parties to store cash on its books. As a result, even if its policy rate remains same, the central bank will pay less to secure the remaining funds if liquidity declines.

“The pace of losses will come down, even if interest rates stay high, because reserves and (reverse repos) are declining as securities run off, and new purchases of securities are earning the new, higher, rates,” English said. But he acknowledged “that’s all very rough” given how many factors and uncertainties are at play.

At $3.3 trillion as of Wednesday, bank reserves were down around $1 trillion from their peak at the end of 2021. Between June 2022 and the end of June this year, the reverse repo daily outstanding levels decreased from above $2 trillion per day to $1.5 trillion on Thursday. This week, the money market trading company Curvature Securities stated in a research note that it’s feasible that by the end of next year, all of the money would have left reverse repos, bringing the facility back to where it was just over two years ago.

The Fed has been giving the Treasury sizable sums of money back for a while, and this money has been used to reduce budget deficits.

The former president of the St. Louis Federal Reserve, James Bullard, stated in an interview on Wednesday that he is “worried” about the losses the institution is experiencing and that “it would be better not to do this.” In order to cover the kinds of losses it is currently managing, he said it probably would have been wiser for the Fed to have kept some of the $1 trillion it has granted the Treasury over the last decade. However, he pointed out that’s not the system Congress has set up.

When the Fed eventually stops losing money, it will be years before it can remove the deferred asset from its books and begin paying the Treasury again. The Federal Reserve returned $76 billion in 2022 which was preceded by the return of $109 billion a year earlier.

Furthermore, the high profit levels were dependent on the then-currently relatively low rates. The Fed’s ability to return to that environment is still up for debate, despite the optimism of some inside the institution, most notably John Williams, president of the New York Fed.

(Adapted from TheDailyStar.com)

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