Federal Reserve Regains Profitability After Historic Losses Linked to Covid Policies

Key Takeaways:

• Federal Reserve returns to profitability after losses tied to the COVID-19 pandemic.
• Deferred asset size of the Federal Reserve has shrunk since the beginning of November.
• Return to profitability driven by the end of negative interest rate spreads and rising market yields.
• Experts anticipate it will take years to replenish deferred assets and resume payments to the Treasury.
• Growing criticism of the Federal Reserve's practices of paying interest to banks.

As reported by Reuters, the U.S. Federal Reserve appears to have finally reversed the course of unprecedented losses incurred over the past three years, losses closely tied to the monetary policies implemented in the wake of the COVID-19 pandemic. Data released by the central bank in recent weeks shows that since the beginning of November, the Federal Reserve has returned to profitability, enough to slowly replenish the accounting line used to cover losses.

Since November 5, the size of the Federal Reserve's so-called deferred asset has shrunk from $243.8 billion to $243.2 billion on November 26. This change, though small, marks a clear turning point in a longer-term trend.

Federal Reserve watchers remain unsure how long it will take to replenish the deferred asset and resume remitting payments to the Treasury, but there is a general consensus that the process will take years. Bill Nelson, a former Federal Reserve official and current chief economist at the Bank Policy Institute lobbying group, noted that the combined profits of the twelve reserve banks in the current quarter are "on track to exceed $2 billion," based on tracking the financial performance of the regional branches.

The deferred asset records the losses that the Federal Reserve must make up before it can remit profits to the Treasury, as required by law. The Federal Reserve's operations are funded through bondholding yields and revenue generated from providing services to the financial sector, and the surplus is remitted to the Treasury.

For most of the Federal Reserve's modern history, this mechanism was a stable source of income for the government. However, the pandemic changed this situation, ultimately leading the Federal Reserve to begin incurring losses in September 2022.

Bond-Buying Spree During the Pandemic

To stabilize the financial system and provide additional economic stimulus, the Federal Reserve bought vast quantities of Treasury bonds and mortgage-backed securities to lower long-term borrowing costs. This more than doubled the size of its asset holdings, reaching a peak of $9 trillion in the summer of 2022.

In 2022, the same year that Federal Reserve asset holdings peaked, challenges emerged. Soaring inflationary pressures forced the Federal Reserve to sharply raise interest rates starting in early 2022, leading to a growing mismatch between its revenues and the funds it needed to pay to banks to maintain interest rates.

Rate cuts have largely ended the Federal Reserve's losses—meaning that the cost of paying banks to maintain the target range for the federal funds rate has decreased. The Federal Reserve's federal funds rate peaked at 5.25% to 5.5% in 2023 and is currently maintained at 3.75% to 4%. Given officials' concerns about labor market conditions, the Federal Reserve may cut interest rates further in the future.

“Overall, the accumulation of deferred assets (losses) appears to have stopped when the interest rate on reserve balances (IORB) was lowered by 25 basis points in October,” said Derek Tang, an analyst at LHMeyer Consulting. “A deeper analysis reveals that this means that profits are coming from the end of negative interest rate spreads, rather than from extraordinary gains such as seigniorage.”

Matthew Luzzetti, chief U.S. economist at Deutsche Bank, stated, “As market yields begin to exceed the IORB, the Federal Reserve’s losses should stop and turn into profits.”

Federal Reserve officials have repeatedly stated that the central bank's profits and losses are unrelated to its ability to execute monetary policy. But some elected officials have criticized the interest-paying authority, arguing that the funds the Federal Reserve pays to maintain short-term interest rates within the target range are essentially a subsidy for the financial sector.