Fed Operating Losses Seen Growing with Higher Interest Rates

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(Bloomberg)—Higher interest rates could force the Federal Reserve to incur greater operating losses on its portfolio of assets and pause remittance payments to the US Treasury Department for “some time,” undercutting a source of government revenue, according to new projections from the New York Fed.

“This negative net income is a result of policy rate increases undertaken by the Federal Reserve in its pursuit of its congressional mandate of maximum employment and price stability,” the New York Fed said in a report released Tuesday. “Over time, net income would be expected to turn positive again.”

The Fed said last month that it recorded a deferred asset of $16.6 billion in 2022 after ceasing remittances to the Treasury. In its audited financial statement for 2022, the US central bank said payments to Treasury totaled $76 billion before they were ended, compared with $109 billion for the year before.

Fed officials rapidly increased interest rates over the past year to fight the strongest inflation in a generation, bringing their benchmark rate to a target range of 4.75% to 5% last month, up from near zero a year ago.

The central bank also began shrinking its balance sheet last year, and is now reducing holdings at a pace of up to $95 billion a month.

The Fed’s rate hikes have increased what the US central bank pays on its liabilities, including the interest it pays on reserves that commercial banks park with the Fed and the interest paid on cash parked overnight at the reverse repurchase facility.

In September 2022, those payments became greater than the interest the Fed earns on its bond holdings. That’s tipped the Fed into operating losses, creating a hole that may ultimately require the Treasury to issue more government debt.

Other notable takeaways:

Increase in market interest rates across the yield curve drove an unrealized loss position for the domestic portfolio of $1.08 trillion, compared to an unrealized gain position of $127.9 billion in 2021. The Treasury portfolio decreased to a $672.8 billion unrealized loss in 2022 from a $134.6 billion unrealized gain the prior year.

Weighted average maturity of Fed’s Treasury securities holdings, about 7.9 years, remained significantly higher than that of the outstanding Treasury universe, which is about 6.2 years. Difference is reflective of Fed’s larger holdings of longer-maturity nominal securities — 10 to 30 years — relative to the stock of outstanding securities.

Central bank assumes portfolio declines through mid-2025, with monthly reductions averaging close to $80 billion through mid-2024, after which the pace slows as caps are reduced. By this time, the size of the portfolio is projected to be maintained at roughly $6 trillion for a little over a year.

Significant growth in usage of the reverse repo facility in 2022 was driven by the attractiveness of the award rate relative to other short-term money-market rates, as well as a preference for shorter duration investments, mainly from money funds. Fed assumes balances will decline to a “minimal level” by the end of 2025 at a pace similar to that of balance sheet reduction.

© 2023 Bloomberg L.P.


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