The inflows have exceeded the outflows generated by the Fed balance sheet since 2008.  However, increasing interest rates have flipped the balance for the first time. Let’s break it down and discuss what, if anything, it means for Fed operations.

EconExtra is a series of posts that go beyond the textbook, helping you incorporate current events into your classroom. This week: Monetary Policy.

Balance Sheet and Interest Flows Explained

Pre-2008: The Fed balance sheet was roughly $1 trillion, consisting mostly of currency. Short-term interest rates were manipulated by adjusting the reserves.

2008: The Fed started to buy up Treasuries and Mortgage-backed securities (MBS). This was known as Quantitative easing and was implemented in an effort to keep liquidity in the capital markets during the Great Recession. The Fed was then earning interest on their holdings of Treasuries and MBS. They also started to pay banks interest on reserves and overnight loans called reverse-repurchase agreements to help manage short-term interest rates. Remember that interest rates dropped to virtually zero in 2008 and basically stayed there until the late 2010s, returning to zero again at the beginning of the Covid pandemic. That meant that virtually all of the interest earned was remitted to the Treasury and supported the Federal budget. For many years these remittances totaled about $100 billion/year.

2022: Interest rates start increasing, and are now above the average 2.3% the Fed is earning on its balance sheet holdings, which now total $8.3 trillion. The Fed’s holdings are shrinking as the Fed is allowing up to $95 billion to mature each month and roll off the balance sheet (Quantitative Tightening).

Beginning last month, the Fed is now paying out more in interest on reserves than they are receiving on the assets on the balance sheet, and this is projected to continue through 2024. The losses are accounted for as a “deferred asset.” When the Fed starts to bring more money in than it pays out again (projected to happen within about two years), this balance will be drawn down “or paid off” before any surplus is remitted to the Treasury.

What Does This Mean?

These operating losses at the Fed are basically a non-issue, as they are allowed to create a “deferred asset” to accumulate any shortfall. While a normal business could not continue to operate in the red this way, it will have little bearing on how the Fed operates. The only potential issue is that it creates a bit of a political soft spot because it hasn’t happened before.  And the interest payments to banks may add up in the coming months/years, which might also make some folks uncomfortable.

An interesting point of contrast, the Bank of England is not allowed to operate this way. It has to get an infusion from the Treasury and can’t carry a deferred asset balance.

Discussion Questions

It may be sufficient for students to read this blog post to get a picture of the issue if  you are unable to access the articles below from behind a pay wall. (BTW, it looks like the WSJ is offering digital access for $1/week—not sure for how long.)

1) Check for understanding of the direction and size of the interest flows.

a) Why was the Fed earning more interest than it was paying for the last 13+ years?

b) Can you name the two key factors that are contributing to the shift from inflows to outflows in the past year?

2) Do you think the Fed should be able to simply track the losses and repay them when they begin to see net inflows of interest in the future, or should the US follow the example of other central banks, like the Bank of England, and get an infusion of funds from the Treasury whenever they run a deficit?  Why?

Resources

Higher Interest Rates Fuel Losses at the Federal Reserve, WSJ-subscription may be required.

UK Treasury to Transfer £11 Billion to the Bank of England to Cover QE Losses, Bloomberg-subscription may be required.

About the Author

Beth Tallman

Beth Tallman entered the working world armed with an MBA in finance and thoroughly enjoyed her first career working in manufacturing and telecommunications, including a stint overseas. She took advantage of an involuntary separation to try teaching high school math, something she had always dreamed of doing. When fate stepped in once again, Beth jumped on the opportunity to combine her passion for numbers, money, and education to develop curriculum and teach personal finance at Oberlin College. Beth now spends her time writing on personal finance and financial education, conducts student workshops, and develops finance curricula and educational content. She is also the Treasurer of Ohio Jump$tart Coalition for Personal Financial Literacy.