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Federal Reserve Update: Fed Reports Third Consecutive Quarterly Loss – Expect More Losses Ahead

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Federal Reserve, FED target and speed to raise interest rate concept, hourglass or sandglass on cube wooden block with alphabet building acronym FED on wooden table with dark background

Last week, Fed Chairman Jay Powell gave a keynote address at the Jackson Hole Economic Symposium hosted by the Federal Reserve Bank of Kansas City. Powell emphasized the Fed’s commitment to reducing inflation to their long-term target of 2% and highlighted the importance of the core PCE measure. Though last month’s core PCE of 4.3% is encouraging, there is still progress to be made before achieving the long-term target. The Fed will need to assess upcoming data to determine their next actions.

The Federal Reserve Banks Combined Quarterly Financial Report for June 30, 2023 was also quietly released during the Symposium. The report revealed that the Fed had an operating loss of -$29.7 billion for the second quarter of 2023.

Second Quarter 2023 Operating Results

In the report, it was disclosed that the Fed’s loss was primarily due to a significant increase in interest expenses. While interest income saw a modest 5.3% increase to $48.5 billion, interest expenses rose to $75.9 billion, a staggering 545% surge compared to the previous year. This increase was attributed to loans extended to banks in March 2023, which yielded higher interest rates than the fixed-rate bonds in the Fed’s SOMA portfolio.

The loans from the banking crisis accounted for 3.7% of interest-earning assets, while the SOMA Portfolio accounted for the remaining 96.3% for the quarter. On the liability side, the Fed paid higher interest rates on bank reserves and reverse repurchase agreements, resulting in increased interest expenses.

Impact of Rate Hikes on Fed Finances

The Fed began tightening in March 2022 to combat inflation, raising the Fed Funds rate by 25 basis points. Over the next 17 months, the rate was raised a total of 10 times, reaching 5.5% from its initial 0.25% rate. As a result of rate hikes, the cost of the Fed’s liabilities rose while their fixed interest income remained the same. This led to a shrinking net interest margin, which turned negative in the fourth quarter of 2022.

The trend of losses continued in the following quarters, with -$15.8 billion in the fourth quarter of 2022, -$27.7 billion in the first quarter of 2023, and -$29.7 billion in the second quarter of 2023. These losses are expected to persist, with projected losses of -$30.9 billion in the third quarter and -$32.5 billion in the fourth quarter of 2023.

Challenges Ahead for the Fed

The Fed’s losses have resulted in the creation of a deferred asset account called β€œEarnings Remittances Due To The Treasury.” As losses continue, this account will grow. Additionally, the Fed’s balance sheet is experiencing unrealized losses, which could reach as high as $1.5 trillion. These large losses have consequences for the economy, as creating reserves to cover the losses can be inflationary and ultimately burdensome for taxpayers.

To address the operating losses, the Fed has three options: cutting the Fed funds rate, halting interest payments on bank reserves and reverse repurchase agreements, or reducing the asset/liability mismatch on their balance sheet through quantitative tightening (QT). The Fed is already employing QT but at a slow pace.

Conclusion

While the Fed emphasizes that the losses will not impair its ability to conduct monetary policy, the long-term implications of these losses and unrealized losses are concerning. The Fed needs to better communicate the risks and benefits of its policies and address the potential consequences, as political pressure and scrutiny are mounting. The challenges faced by the Fed underscore the need for careful management of their monetary policy to maintain stable prices and maximum employment.

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