As the United States’ central bank, the Fed’s policy decisions significantly impact our economy, our businesses, and the public. So, when the Fed makes a poor or outright wrong decision, it becomes the subject of public and political scrutiny and will be held accountable.
But the Fed’s accountability is not impressive as the worst “punishment” the Fed can receive might be losing its chairman— unlike banks and other financial institutions, the Fed really can’t fail to a point of insolvency, no matter how badly it messed up.
So, if the Fed loses money and those losses can’t end the central bank, who ends up footing the bill? For decades, questions like these have been irrelevant because the Fed made substantial profits. But today is different.
The Fed’s losses are mounting
For the first time in its 108-year history, our central bank is facing massive losses. It reported net income of $151 billion for the first quarter of 2022, but the calculation doesn’t include the more than $330 billion in unrealized losses in its Open Market Account. If these losses were included, the gain of $151 billion would be replaced with $179 billion in losses.
The Fed’s current bond positions in its portfolio are losing value. As interest rates rise, the value of these bonds drops even further. When the bonds are still in the Fed’s portfolio, these losses are considered unrealized losses, and when the Fed increases the interest rate in the fight against inflation, its unrealized losses increase.
In addition to portfolio losses, the Fed must deal with rising interest payments on its $3.3 trillion in member bank reserve balances and $2.1 trillion in so-called “reverse purchase agreements” while its interest income remains unchanged or declines. There is a possibility that the Fed will experience operating losses never seen before.
Who is supposed to cover the Fed’s losses?
The Fed consists of twelve regional Reserve banks that are funded by national and some state banks — the member banks. The member banks acquire shares in the Federal Reserve banks but only pay for half of the shares, and the Fed can request the amount owed at any time.
Congress clearly intended that the member banks would be liable for Reserve losses. In 1915 — just two years after the central bank was founded — the Fed posted an operating loss and approved a call on money owed by the member banks. They declined. But that experience may have moved the Fed to be creative.
The Fed’s creative accounting practices
If the Fed followed generally accepted accounting principles for financial institutions, recognition of the current unrealized losses would wipe out $61 billion of paid-in capital and surplus and require member banks to meet their financial obligation. However, the Fed is not subject to those rules. In 2011, its Board of Governors adopted unique accounting principles and practices that excluded unrealized gains and losses from income calculations.
The Fed’s Governors then approved an accounting provision to show operating losses as a “deferred asset” on its balance sheet, bypassing the Fed’s income statement. The changes are designed to protect the Fed’s paid-in capital and surplus.
The practice also means that the central bank no longer requires the member banks to meet their contractual obligation. Due to these creative accounting practices, the Fed has never reported a loss or called on the member banks to contribute additional capital.
Who will end up covering the losses?
By choosing to ignore unrecognized losses and the requirements that member banks bear operating losses, the Fed’s losses will continue to grow until interest rates return to their historic lows sometime in the future. Any operating losses will be covered by monetizing the losses — via money printing — and adding to inflationary pressures.
Instead of sharing the pain of the fight against inflation, the Fed drops the financial burden entirely on the public while the member banks will receive higher interest rates on their reserve balances and get dividends on their Reserve bank shares.
Most of the money the Fed has added to the economy over the past few years has benefited mostly the financial elites, which can access these funds, leaving the rest of us with an inflation tax that’s crippling our hard-earned savings.
While many may have to live with additional consequences of the Fed’s actions, you can be proactive by protecting your purchasing power with an asset that historically has performed well under inflationary pressures. That asset, of course, is gold.