In a period of elevated inflation such as we’re currently experiencing, the interaction between fiscal and monetary policies can lead to some curious phenomena. See, for instance, the chart below, which shows that between September and mid-January the US Federal Reserve lost more than $20 billion.
What’s going on here? What does this line represent, and why is it crashing through the floor in the past six months? This chart visualizes an interesting process starting to get underway, and hints at how higher interest rates, which the Fed is using to fight inflation, could end up being a big fiscal issue.
Here’s the story. The Treasury pays the Fed interest on the Fed’s asset holdings of Treasury securities. The Fed pays interest on reserves to banks and to other financial institutions that have, effectively, made deposits at the Fed. As long as the Treasury interest the Fed receives is greater than the interest the Fed pays, the Fed makes money. It spends some, and returns the balance to the Treasury. The Fed also issues cash, which pays no interest, so the Fed makes steady money on the difference between interest-bearing assets and the zero return of cash.
But when the short-term rates the Fed pays rise sufficiently to make its interest expenses greater than its interest earnings, the Fed loses money. It stops sending interest earnings to the Treasury. The chart is in essence the amount the Fed has lost. Usually the Fed makes some money—the chart line goes up—then the Fed pays out to the Treasury and the line goes back to near zero. When the Fed loses money, the Treasury doesn’t send a check to bail the Fed out. Instead, the Fed accumulates its losses, $20 billion so far. The Fed then will wait to make this amount back again before it starts sending money to the Treasury.
For broad-brush macroeconomics, the Fed and Treasury are the left and right pockets of the federal government, so this fact has no direct implications. What it means is simply that as interest rates rise, the government is going to pay more interest on its debt, which includes the Fed’s liabilities of reserves and cash.
The event is revealing, however. The Fed’s massive quantitative-easing operation has undone a lot of the Treasury’s long-term debt, which would have kept interest costs from rising so fast. The Treasury issued long-term debt, the Fed bought it and issued short-term debt instead, and they will share profits and losses. So the Fed’s losses are really just a measure of the extra interest on the debt that QE has caused.
Granted, $20 billion isn’t a huge amount in today’s Washington, but the process suggested by the chart is just getting started.
No, the Fed is not about to go bankrupt. The Fed can print money, so conventional bankruptcy (when you can’t pay bills) simply cannot happen. If the Fed had no assets at all, it could simply print money—create new reserves—to pay the interest on outstanding reserves. That would only come to an end if the Fed had to soak up reserves or cash by selling assets to avoid inflation.
Also, the accounting involved is a little weird. The Fed only counts interest income, and ignores mark-to-market values, when calculating its remittances to the Treasury. So we’re talking about the accumulated interest received on the Fed’s assets minus interest paid on reserves. The Fed has taken a bath in mark-to-market asset values as interest rates have risen. The Fed doesn’t need to worry about it, because it can hold the securities to maturity.
However, this means the Fed will likely have to hold them to maturity. The Fed now has $8.5 trillion of assets. A speedy quantitative tightening, selling those assets, would force the Fed to recognize mark-to-market losses. So don’t count on that event. Fortunately, in my view of the world, QE didn’t do much but shorten the maturity structure of outstanding debt, so the lack of QT won’t be missed. Others disagree.
Alyssa Anderson, Philippa Marks, Dave Na, Bernd Schlusche, and Zeynep Senyuz at the Fed have a very nice analysis of this situation, along with explanations of how it all works. In their baseline projection, the federal funds rate jumps from near zero (where it was in early 2022) to a median of just under 4 percent for 2023 (below where it stood as of mid-January of this year), before gradually declining to stabilize around 2.5 percent.
Under that projection, the Fed’s interest income dips between 2022 and 2025 even though interest rates rise. The Fed is still sitting on old bonds with very low interest rates. Interest income starts rising when these mature, and the Fed reinvests in new bonds with higher interest rates. Interest expense, on the other hand, responds much more quickly to the rise in rates as the Fed pays higher interest on reserves, but the projection largely follows the reasonably rosy scenario that the funds rate eases as inflation goes away, bringing expenses down with it.
The bottom line in their projection is that remittances to the Treasury stop for a few years while interest expense is greater than earnings, but then pick up again once the Fed can roll over its asset portfolio.
All well and good, but I can think of plenty of ways this can go wrong! Suppose inflation does not fade away and substantial interest-rate hikes are needed. Suppose, for example, we replay 1980, when short-term interest rates shot up to nearly 20 percent—except this time with the Fed maintaining a huge balance sheet, and paying interest on reserves.
If short-term rates reach the level of the 1980s, the Fed’s interest expense could rise to $1 trillion. High yields on government bonds would also be costly for the Treasury.
The Fed’s $8.5 trillion in assets corresponds to about $6.2 trillion of interest-paying liabilities, including $3 trillion of reserves and $2.5 trillion in reverse repos (essentially reserves for nonbank financial institutions), plus $2.3 trillion of currency. Even assuming people still will hold that much currency as interest rates spike (they won’t, and didn’t in 1980), $6.2 trillion times 15 percent equals nearly $1 trillion of interest expense. Now we are talking real money. The Fed’s maturity shortening via QE will cause the government an extra $1 trillion of deficit per year.
And this is the tip of the iceberg. The Treasury will also have to refinance all the debt that the Fed is not holding at the same higher interest rates. The Treasury debt isn’t that long term either. The federal government is a lot like a couple that bought a megamansion they can’t really afford and took out an adjustable-rate mortgage. If rates stay high for very long, that will start to get very expensive indeed.
John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and was previously a professor of finance at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.
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