Could the Fed Go Broke?

Summary

• The Fed is hiking interest rates rapidly to combat sky-high inflation but doing so means it must pay more interest on its liabilities.
• If it keeps hiking, it may have to pay so much interest that it effectively goes broke in 2023.
• The Fed could reduce how much interest it pays by more quickly reducing its balance sheet (quantitative tightening). But this could require outright securities sales, which would involve large capital losses.
• Ultimately, the Fed’s framework could prove politically unsustainable and undermine its ability to stabilize inflation.

Market Implications

• Concerns over operational losses could see the Fed fall further behind on hiking, leading to yield curve inversion.
• Though this could lead to higher growth and inflation in the short term, markets would likely look through these and anticipate greater eventual tightening and recession.

The Fed Is Navigating Unchartered Waters

Since the GFC, the Fed has assumed lowering inflation is easier than raising it. But raging price rises, with CPI at 9.1%, are prompting a few raised hands.

The question so far has been this: is the Fed willing to tighten policy enough to stabilize inflation? But no one seems to be asking whether they are able to tighten it… Everyone is taking it for granted. After all, Chair Jerome Powell said it was ‘likely to be relatively simple.’ Who would challenge that?

Yet as it nears restrictive territory, the Fed will probably struggle much more than expected to effectively tighten policy.

This may sound counterintuitive. How can a central bank be unable to tighten policy? Yet few realize the Fed’s current operating framework – based on abundant reserves – is largely untested, especially amid runaway inflation. 

Hiking Could Put the Fed in the Red

Like anyone else, the Fed receives interest on its assets and pays interest on its liabilities. As the Fed hikes the federal funds rate (FFR), however, it will have to pay higher interest on its liabilities (on reserves, RRP, and TGA). Meanwhile, the interest rate it receives on its assets (its securities portfolio) will change little. This means its net income from interest rates will fall.

How Bad Could It Get?

I think the Fed will keep hiking interest rates aggressively – ultimately to 8% by end-2023. This is far higher than the predictions in the Fed’s June Summary of Economic Projections (Chart 1).

Alongside some other key assumptions (Appendix), we can model just how much hot water this hiking will land the Fed in through 2022-3.

Under my scenario, the Fed’s net interest income would turn negative this month (Chart 2).  For the whole of 2022, it would fall to $33bn from $123bn in 2021. In 2023, net interest income would become minus $230bn, and interest payments on reserves, RRP and TGA would represent $357bn.

With the Fed’s capital currently representing $41.7bn or 0.5% of total assets, policy tightening would effectively wipe out Fed equity in 2023. Put another way, the Fed will go broke.

What If the Fed Does Not Hike to 8%?

I ran an alternative scenario assuming the interest rate trajectory shown in the June SEP. This is interest rates up to 3.25-3.50% in 2022 and 3.75-4.00% in 2023.

Even under this scenario, the Fed’s interest income would fall to negative $83bn in 2023, i.e., still wipe out Fed equity.  

What Could the Fed Do?

The Fed could reduce how much interest it pays by more quickly reducing the size of its balance sheet (quantitative tightening). For various reasons, this would likely require outright sales of its securities portfolio.

But outright sales could entail substantial capital losses as yields are now higher than during most of the post-GFC era of quantitative easing. With the Fed’s capital representing about 0.5% of its securities portfolio, outright sales would very quickly wipe out the Fed’s equity.

Fear of Losses Is Constraining Fed Policy

Operational losses could have serious consequences for Fed policy. First, the payments of hundreds of billions to banks and money market funds is likely to prove politically contentious.

With populism on the rise, politicians on both sides of the aisle could argue that the Fed’s interest payments are regressive and inefficient. 

Second, if the Fed booked a loss, it would have no profits to remit to the Treasury. Since 2010, it has given about $80bn a year to the Treasury (up from $30bn pre-GFC). This represents about 25% of the Treasury non-tax revenues. This could worsen the relationship between the Fed and Congress, which is already tense as several GOP politicians think the Fed has gone ‘woke’ at the expense of its inflation stabilization mandate.   

Third, running into the red could make the market see the Fed as fragile and dependent on the Treasury. That could undermine its credibility, especially in fighting inflation.

Market Consequences

Concerns over operational losses could see the Fed fall further behind on hiking, leading to yield curve inversion. Though this could lead to higher growth and inflation in the short term, markets would likely look through these and anticipate greater eventual tightening and recession.

Appendix

Key assumptions are:

• The average interest rate earned on securities holdings remains at the 2021 level.

• The FFR path (Chart 1), i.e., end-2022 FFR between 4% and 4.25% and end-2023 FFR between 7.75% and 8%.

• The RRP rate remains 5bp above the lower bound of the FFR target range and the IOR 15bp above.

• Assets outside of securities holdings are unchanged.

• QT remains as described in the May FOMC memorandum, i.e., a monthly roll-off of $30bn in Treasury securities up to August and $60bn afterward (Chart 2).

• No outright sales of MBS even though less than $2bn in MBS securities will mature within the next five years (more on this later). Also, with mortgage rates the highest since the GFC, mortgage pre-payments appear highly unlikely unless yields fell substantially, which is unlikely since the Fed is tightening policy. In sum, the MBS reinvestment caps announced in May will not materially impact the MBS portfolio for the next five years.

• Reserves and RRP decline each by half of the security portfolio decline minus the change in the TGA (for discussion of the reserves/RRP breakdown, see QT2: Beware of regime change). Per the latest Quarterly Refunding Statement, I assume the TGA (that gets remunerated at IOR) reaches $700bn by end-2022 and is unchanged in 2023.

• Currency issuance slows as it continues to return to pre-pandemic trends.