No Easy Exit Emerges for the Federal Reserve as It Runs Up Mind-Boggling Losses

The Federal Reserve’s accumulated operating losses reached $234 billion as of July 2. A mind-boggling sum. Subtracting these losses from its paid-in capital and retained earnings, which together total $46 billion, shows the central bank’s real capital is negative $188 billion.

Meaning — its losses have run through all the capital its private bank shareholders invested and the associated retained earnings five times. This is embarrassing for the greatest central bank in the world, which certainly did not plan to lose this much money. Neither were these huge losses expected by Congress or by American taxpayers.

The Fed’s losses in excess of its capital are a cost to taxpayers. Its negative capital means it has borrowed and spent nearly $200 billion dollars of public money without the approval of Congress, solely to which the Constitution grants the power to borrow money on the credit of the United States. The Fed took an enormous financial risk without the approval, and perhaps without the awareness, of Congress.

The Fed’s losses reflect the simple fact that the interest expense it pays, primarily on the deposits held with it by private banks (often called “reserves”), is far greater that the interest income it earns on the $6 trillion of investments it bought mostly at the top of the market in bond prices, a market top created by its own massive buying. This means that the Fed bought at the bottom of yields on those bonds.

The result is that in, say, 2024 the Fed had $159 billion in interest income, but $227 billion in interest expense, of which $186 billion or 82 percent of this expense was interest paid on its deposits from banks. It lost $68 billion even before paying any of its operating expenses, and had a net loss of $77 billion for the year.

A temptingly simple solution to the losses comes to mind. As suggested by Senator Cruz, just stop paying interest to the banks on their deposits. In 2024, this would have reduced the Fed’s expenses by $186 billion, flipping its $77 billion loss to a pro forma net profit of $109 billion.

As Mr. Cruz rightly points out, for most of its history the Fed paid no interest on its deposits. Indeed, from its founding in 1913 to 2008, or for 95 years, the Federal Reserve Act prohibited Federal Reserve Banks from paying any such interest, so the private banks automatically got zero interest on their Fed accounts.

Naturally, the banks did not like this, viewing it not unreasonably as a tax. They finally succeeded in getting the law changed, then the change accelerated with the support of the Fed, which was about to launch an unprecedented expansion of its balance sheet and wanted the banks to be happy holding far bigger deposits with it than ever before.

The banks now have about $3.3 trillion in deposits at the Fed. In June 2008, still under the old system, the total Fed deposits from banks were only $13 billion. The banks’ deposits with the Fed are now more than 250 times what they were then.

At this point, the Fed is paying on its $3.3 trillion in deposits from banks at an interest rate of 4.4 percent. This means it incurs an annualized cost of $143 billion; dropping that expense would easily make the Fed profitable again going forward. In the first instance, the government would like the Fed, and therefore the government, to keep that money.

Then what would happen, though? If the banks didn’t like getting no interest on $13 billion, imagine how they would hate getting none on $3.3 trillion. Their income would just have dropped by $143 billion a year.

Each individual bank would try to get out of its now zero-income deposits by investing in something else. It might buy Treasuries or other securities, invest in mortgages, make new loans of all different kinds, or all of the above.

As all of the banks did this together, interest rates would fall in an inflationary credit expansion. The Federal Reserve would have lost control of interest rates, which it would not accept, since one of its essential roles is to be the national price-fixing committee for interest rates.

Because of the magic of a fiat currency central banking system, no matter how much the individual banks reduce their individual Fed deposits, the aggregate banking system cannot reduce its aggregate Fed deposits. They would still be $3.3 trillion unless the Fed itself reduced them. The government would have forced the banks as a whole to provide it with $3.3 trillion of free funding. It would be fair to call this financial oppression.

The Fed could reduce its deposits by selling its own investments and shrinking its balance sheet. Yet the Fed has a nearly $1 trillion unrealized loss on its investments. By selling it, the central bank would realize large losses — not to mention driving the market against itself.

The Fed will not do this. So in sum, considering Mr. Cruz’s idea leads to the conclusion that there is no easy way out of the upside-down financial position the Fed has gotten itself in.

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No Easy Exit Emerges for the Federal Reserve as It Runs Up Mind-Boggling Losses