Workforce Reductions and Financial Losses

This month, the Federal Reserve announced a plan to reduce its workforce by 10% over the coming years. While this decision is perceived as a cost-cutting measure, it also reflects a more significant issue: the Fed is currently operating at a financial loss—a situation not openly discussed.

The Fed’s Unique Operating Model

The Federal Reserve, like any bank, manages assets and liabilities on its balance sheet. When loans are issued by commercial banks, they create both an asset—a loan—and a corresponding liability, which is the new deposits added to customer accounts. This new money creation is fundamental to banking operations.

Unlike standard banks, the Fed’s liabilities consist of both physical dollar notes and reserves, marking these as deposits within its own system. This translates to a straightforward banking model; however, the implications for profitability differ significantly.

Shifting Dynamics of Profitability

Traditionally, banks operate with the goal of profitability, ensuring that returns on assets surpass the costs of liabilities. However, macroeconomic consensus suggests the Fed operates under different principles, given its ability to print money. This notion leads to the belief that losses are inconsequential, though it overlooks the political gravity of seigniorage—the profit acquired from currency issuance.

Until very recently, the Fed reliably generated profits, redistributing earnings to the government. This financial strength not only enhanced its independence but also bolstered its political stature.

Impact of Interest Payments on Reserves

The Fed’s liabilities historically incurred no costs, largely because physical dollar notes do not accrue interest. However, with changes instituted during the 2006 financial crisis, the Fed began paying interest on reserves held by commercial banks. As a result, banks became accustomed to holding more reserves, leading to the emergence of what is known as the ample-reserves regime.

In this scenario, interest rates are managed by altering the interest on reserves, fundamentally linking the Fed’s expenses to the interest it pays, which can lead to significant losses.

Recent Financial Losses and Future Considerations

In 2023, the Fed reported a substantial operating loss of $114 billion, with projections of another $78 billion in losses for 2024. This shift marks a significant departure from previous assumptions that the Federal Reserve would always be safeguarded from financial failure, as government support is typically expected in times of crisis.

These losses raise questions about the Fed’s role and responsibilities, especially as the long-term viability of cash profits diminishes. With the rise of digital payment systems, the traditional profit margins from cash may transition from the Fed to private entities.

Conclusion: A Call for Clarity

The current landscape surrounding the Federal Reserve is complex and ever-evolving. As it grapples with losses and restructures under new policies, it is vital for Congress and the White House to clarify expectations regarding profit and loss. Understanding the nature of this central bank is essential, especially during these non-traditional economic times.