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The writer is a contributing editor for FT.
This month, the Federal Reserve decided that it would cut its own workforce by a tenth over the next few years. The move has been reported as a way to find savings in the Fed before so-called government efficiency knocks on the door. That may be correct, but there is another issue the Fed doesn’t want to talk about. It’s at a loss. intentionally.
When a commercial bank lends you money, it adds both assets and liability to its own balance sheet. The assets are the loan itself and are repaid over time. The responsibility is a brand new deposit, and it is marked from scratch in your account. These deposits are brand new money.
The Federal Reserve is a special bank, but it is still a bank. Adding assets to your own balance sheet, such as the Treasury or mortgage-backed securities, matches your liability in either the latest physical dollar notes or the latest deposits. We call deposits of the Fed reserves, but they are just deposits. This has no magic and no special money creation. It’s just a bank.
The key to commercial banks is to operate profitably and maintain profits on assets that are higher than the cost of liability. However, macroeconomicists have come to believe that this is not the case with the Fed. Losses are irrelevant as it is likely to issue dollars and always issue more. However, this is an assumption, not a law of physics. What it overlooks is Zeniorage’s political significance. This is the benefit to the sovereign state’s financial resources to produce money.
Until 2023, the Fed was consistently profitable. The return on the asset was higher than the cost of its liability. It returned some of this profit to the government, demonstrating its strength as both a bank and a political institution. It’s easier to stay independent of the White House when you’re paying for privileges.
The Fed’s debts cost it none. First, they do not pay interest, despite the fact that physical dollar notes are the Fed’s responsibility. Second, commercial banks have always had to hold a portion of their assets as Fed deposits – reserves. The Fed also paid no interest on these until the 2006 law was implemented during the start of the 2008 global financial crisis.
Traditionally, bankers have felt that children retain the way they feel about bathing. They are against it, but that’s not the point, as it’s not their decision. The reserves are not meant to make a profit – they appear to be safe. However, this need wasn’t too painful once the Fed began preparing. Banks are used to holding secure assets with small but guaranteed returns. They began to hold more reserves than they needed to.
Now, the Fed is stuck on an operating system that bankers call a sufficient absorption regime that they love bathtime. Under this regime, the Fed implements interest policies by moving profits paid for delivery up and down. Essentially, it determines how much you will lose from that debt. This is not quantitative mitigation in emergencies, but rather normal operations. In 2023, the Fed reported a loss of $114 billion. 2024, $78 billion.
This is an uncontroversial departure. The reason we assume the Fed is likely unable to fail is because Congress will always protect the central bank with new capital promises in emergencies. Now in a completely normal year, the Fed can suffer losses if it raises interest rates.
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The Fed reserves these losses as what they call deferred assets. This is a privilege inherent to the Fed, an implicit understanding that there are lean, fat years, and will balance each other out as prices drop again in the future.
The Fed may also be able to eliminate profits when it issues dollar cash. Cash continues to decline as a percentage of total payments. Republicans in the White House and Congress have made it clear that the Fed is not replacing other types of liability, such as digital currency, with their own balance sheets.
At the same time, the Senate bill must instead bring Stablecoins Providers into the regulatory system, where it must retain assets against any property of the Fed’s coins, insurance contracts, insurance bank deposits, or treasury agreements. This means that over the long term, Fed cash profits have been moved to the private sector.
This was not significant in the normal times when the Fed was supported by a consensus between Congress and the White House on monetary policy norms. But these are not normal. The Federal Reserve is a bank. And we need to be clear exactly whether Congress and the White House expect profits and what they do about the losses.
