Federal Reserve Reports Annual Net Operating Losses for the First Time in a Century, What Does it Mean?

According to the Fed's Combined Quarterly Financial Reports, for the first half of 2023, the Fed's total interest income was $88.39 billion, and total interest expense was $141.85 billion, resulting in a net interest loss of $57.38 billion. The Fed's losses could persist throughout 2023.

The Fed's income and losses are primarily determined by the difference between the interest income generated by the securities it holds in the SOMA portfolio and the interest expense associated with its deposits.

The Fed's interest income and expenses fluctuate with changes in policy interest rates. From the perspective of interest income, the income responds slowly to changes in policy interest rates. Higher interest rates will only lead to higher interest income when the Fed reinvests maturing securities for reserve management purposes. Most US Treasury bonds held by the Federal Reserve have maturities of more than one year. More than 97% of MBS held has a maturity ofmore than ten years. Besides, most securities were purchased right after the epidemic, when coupon rates were quite low.

From the perspective of interest expenses, the expenses are directly linked to the policy interest rate, so they can be quickly adjusted. For example, the term of the reverse repo is within 15 days.

Therefore, the risk of the Fed's earnings results from the inherent maturity mismatch between the assets and liabilities on the Fed's balance sheet.

Another concept that is often discussed is unrealized gains and losses. As of June 2023, the Fed's SOMA portfolio had net unrealized gains and losses of -$1.01 trillion. It is the difference between the security's market value and its amortized cost. However, unrealized gains and losses will not impact the Fed's net operating income. The market value of a security tends to its face value as it approaches maturity, and for securities held to maturity, any gains or losses due to interest rate fluctuations remain unrealized.

According to the Federal Reserve's research and statements, net operating losses and unrealized gains and losses will not have an impact on the Federal Reserve's monetary policy. The Fed's mission is neither to make profits nor to avoid losses. Even as the SOMA portfolio's unrealized loss position grew larger and the Fed's projections turned negative, the Fed was still able to meet all of its responsibilities.

However, that doesn't mean the Fed's losses don't have any negative consequences.

In 2022, the Fed still remitted $76 billion to the Treasury through August. But then it started making losses and there was no more income to remit. Since 2001, the Fed has remitted $1.36 trillion in income to the Treasury. Those remittances will be zero for years to come.

According to the Federal Reserve Act, after paying operating costs, dividend payments, and any amount required to maintain surpluses, the Federal Reserve remits all of its Net Income to the US Treasury.

If net income becomes negative, remittances to the US Treasury will be suspended. During peak periods, Federal Reserve remittances accounted for more than 3% of Treasury revenue.

The Federal Reserve Act requires member banks to contribute additional funds to cover the operating losses of regional reserve banks. If the Federal Reserve requires regional reserve banks to pass operating losses to their shareholders, the capital adequacy of some member banks could become vulnerable.

Since the Fed still needs to meet its financial obligations, remittances to the Treasury will be suspended, and deferred assets will be recorded on the Fed's balance sheet, representing a claim on future net profits that the Reserve Bank needs to realize before resuming remittances to the Treasury.

Currently, if the Fed faces an operating loss, it does not reduce its book capital surplus but simply creates the money needed to meet operating expenses and offsets the newly printed money by creating a fictitious "deferred currency" on the balance sheet. Subsequently, when the Reserve Bank begins to generate positive operating income, after paying dividends, the Regional Reserve Bank will use any remaining income to reduce the deferred asset balance to zero before resuming remittances to the U.S. Treasury. In principle, the way bank reserves are created may make it more difficult for the Fed to control inflation.