How to understand the Federal Reserve’s nearly $200 billion in losses?

Can you understand how the Federal Reserve, the largest and by far the most important central bank in the world, has now lost a staggering $193 billion? If not, you are certainly not alone. The Fed has lost money every month since September 2022. These unprecedented losses continue and will total more than $200 billion this fall.

The Fed has a powerful mystical aura that it works hard to cultivate. It wants intensely to be credible—that is, to have you believe in it (“credo” is Latin for “I believe”), and maybe you do. People’s faith is an important source of the Fed’s power, and its power is an essential source of the government’s power.

We can say with certainty that the Fed prints power by printing money. The Fed doesn’t want small things like $200 billion in losses to shake your faith—like the Wizard of Oz, he says, “Pay no attention to this man,” or those losses “behind the curtain.” It hides its losses behind an accounting curtain that pretends the losses are assets.

These operating losses are not, as is sometimes incorrectly said, mere “paper” losses. They are true cash losses. The Fed has negative net interest income because its cost of funds is much higher than its investment income. The operating losses of $193 billion exceed the Fed’s total capital of $43 billion by more than four times.

So right now there are no profits, no retained earnings and no capital. addition on top of that, it had a market loss of more than $1 trillion, according to financial statements through June 30. How is that possible? How can a bank with a hugely profitable monopoly on issuing the world’s dominant reserve currency lose a fortune?

To understand the Fed, or any central bank, one must divide it analytically into two distinct parts and consider the functions and profits of each separately. The Fed does not do this, although the logic is classical and was already required for the Bank of England by the Bank Charter Act of 1844, also called “Peel’s Bank Act” after Sir Robert Peel, the prime minister who promoted it.

The Bank of England was divided by Peel’s Act into a Department of Issue and a Department of Banking. The idea at the time was to link paper currency closely to gold. This has disappeared both in theory and in practice, but the Bank of England still keeps its books in accordance with this basic division of functions. The Fed should do likewise.

The Fed’s issuing function uses its government-granted monopoly on issuing U.S. currency. Its liabilities are $2.3 trillion in outstanding currency, paper dollars held not just in America but all over the world. From a profitability perspective, these are great liabilities for a central bank.

The currency is a non-interest bearing, perpetual, irrevocable source of funds. The Issue Function’s assets are $2.3 trillion of investments financed by the issued currency. These investments are typically government bonds.

Why Issuing Currency So Profitable? If the Fed’s issuing function had used its $2.3 trillion in 2023 to simply buy Treasury bills, it would have received about a 5 percent yield. The result would have been an interest expense of zero and an interest income of $115 billion.

If operating expenses were $1 billion (a guess), net profit would have been $114 billion. It looks like Issue Function unwisely, and perhaps foolishly, invested its funds in long-term bonds at 2 percent, the rock bottom of interest rates. Yet in 2023 it had a profit of $45 billion.

The Federal Reserve as a whole lost $114 billion in 2023, regardless of the gains from the Issuance. That means the Banking Function — the rest of the Fed, with its QE investments, mortgage-backed securities, deposits, loans, spending, and big risks — actually lost $114 billion plus a whole $45 billion in profits from the Issue Function currency monopoly. So the Fed’s Banking Function lost $159 billion in 2023 — and that’s in just one year.

I estimate that over the two years ending September 30, the Fed’s banking function will lose about $290 billion. Quite a lot, and the losses will continue. If the Fed were to adopt a two-department approach, it would help Congress and the public understand what it is doing, with a nod to Sir Robert Peel.