Fed faces years of losses as interest rates rise

The US Federal Reserve is set to face years in which it suffers losses due to the effects of interest rate risk stemming from its hefty asset holdings.

The balance sheet peaked at a size of $8.97 trillion in April and has shrunk only slightly since then as quantitative easing unwinds, declining to $8.9 trillion on July 11. By purchasing bonds during the Covid-19 crisis, the Fed brought interest rate risk onto its balance sheet, helping to stabilise markets, cut government borrowing costs and generate returns for the central bank.

Now, as interest rates rise rapidly, returns are set to turn to losses, and US taxpayers will have to foot the bill.

Instead of requesting recapitalisation from the Treasury, the Fed plans to record a “deferred asset” on its balance sheet, reflecting the amount of future net income that will be required to cover losses. Until the deferred asset is run down to zero, the Fed will not pay a dividend to the government.

Analysis by Fed economists published on July 15 projects a range of possible scenarios, depending on how high interest rates climb in response to rising inflation.

In the baseline projection, the deferred asset peaks at about $60 billion in 2024 and then falls to zero by 2026, allowing dividend payments to restart that year.

But the economists acknowledge there are major risks to the outlook – the upper edge of the 90% confidence interval peaks at about $180 billion. In such a case, the losses would likely not be paid off until beyond 2030. The authors stress the scenario is “purely illustrative” given the high level of uncertainty over future policy and economic conditions.

Central banks do not need to be solvent to operate, since they can be recapitalised by the government as long as tax revenues are available. Some have operated with negative equity for extended periods.

“While the expansion of the Fed’s balance sheet in response to the pandemic may have increased the risk of the Fed’s net income turning negative temporarily in a rising interest-rate environment, the Fed’s mandate is neither to make profits nor to avoid losses,” the economists point out in their note.

But incurring losses can create political frictions, especially at a time when government budgets are very stretched.

For financial firms that are carrying high levels of interest rate risk, the threat of insolvency could be more serious. Economists Marina Misev and Philip Turner warn exposures are opaque and could become a threat to financial stability as rates rise.