What Would Happen If the Fed Incurred Losses? (2024)

After more than a decade of quantitative easing (QE) in the aftermath of the 2008 financial crisis, central banks around the world are taking a hit to their profitability as they unwind their balance sheets and raise interest rates.

CNBC on Wednesday reported that the Bank of England will lose $30 billion more than expected over the next two years on bond purchases made from 2009 to 2022. The U.K.'s central bank has tightened monetary policy rapidly to get rampant inflation under control.

Rising interest rates have crimped central banks' profitability in recent months. When rates rise, interest payments on central banks' liabilities tend to spike, while the interest income earned on their assets stays relatively fixed. The Swiss National Bank (SNB) took one of the biggest hits to profitability last year, losing the equivalent of $143 billion, a sum equal to roughly 18% of Swiss gross domestic product (GDP).

Under these circ*mstances, you may be asking: What happens when central banks incur losses?

What a Loss For The Fed Could Look Like

During most years, central banks tend to earn a profit as the interest they earn on their assets exceeds the interest paid on liabilities. In the case of the U.S. Federal Reserve, the Fed earns more interest income on its holdings of Treasury bonds and mortgage-backed securities (MBS)—which together account for more than 90% of the Fed's assets—than it pays out to private banks that hold a portion of their funds in accounts at the Fed.

Central banks transfer any excess profits they earn to their nation's government or fiscal authority. The Fed distributes any profits it earns from its asset holdings as remittances to the U.S. Treasury, helping finance the federal government's operations and pay off the budget deficit. If the Fed were to incur losses over a prolonged period, it would no longer be able to finance the Treasury, which could lead to serious budget constraints.

Under the Fed's accounting rules, any losses to its portfolio are classified as "deferred assets," which would need to be paid down once the Fed returns to profitability. Once that happens, the Fed would be able to resume transferring funds to the Treasury.

Rising Interest Rates and QT

The Fed has raised its benchmark interest rate 12 times since March of last year, to a range of 5.25%-5.5% from near zero during the pandemic, in an effort to tame the highest inflation in four decades.

During this time, the Fed has also engaged in "quantitative tightening (QT)," which refers to the winding down of its balance sheet by either selling income-generating assets like Treasurys and MBS, or allowing them to mature without reinvestment and "roll off" the Fed's balance sheet.

As a central bank unwinds its assets, it earns less interest income on them, hurting profitability. As such, rising interest rates coupled with QT have resulted in a double whammy for central banks' profitability.

Quantitative easing, or QE, has the opposite effect, as a central bank increases its asset holdings and earns more money on income-generating assets. In 2021, amid record QE meant to stimulate the economy during the pandemic and before the Fed started raising interest rates, remittances to the Treasury surged to a record $109 billion, up from $55 billion two years prior.

No Risk of Default

Unlike standard commercial banks, central banks like the Federal Reserve can't default because—as the monetary authority of a nation—they can always create the necessary reserves to pay their bills. Moreover, due to reserve requirements mandated by law, banks must hold a certain percentage of their funds as reserves at the Fed, meaning that the Fed cannot experience a bank run.

If the Fed were to incur losses, it would have no detrimental effect on its monetary policy tools, such as open market operations (OMOs) or setting the federal funds rate. The Fed would still be able to raise or lower interest rates or buy and sell securities on the open market in order to influence the economy.