(Bloomberg) — Profits and losses aren’t usually thought of as a consideration for central banks, but rapidly mounting red ink at the Federal Reserve and many peers risks becoming more than just an accounting oddity.
The bond market is enduring its worst selloff in a generation, triggered by high inflation and the aggressive interest-rate hikes that central banks are implementing. Falling bond prices, in turn, mean paper losses on the massive holdings that the Fed and others accumulated during their rescue efforts in recent years.
Rate hikes also involve central banks paying out more interest on the reserves that commercial banks park with them. That’s tipped the Fed into operating losses, creating a hole that may ultimately require the Treasury Department to fill via debt sales. The UK Treasury is already preparing to make up a loss at the Bank of England.
Britain’s move highlights a dramatic shift in countries including the US, where central banks are no longer significant contributors to government revenues. The US Treasury will see a “stunning swing,” going from receiving about $100 billion last year from the Fed to a potential annual loss rate of $80 billion by year-end, according to Amherst Pierpont Securities LLC.
The accounting losses threaten to fuel criticism of the asset purchase programs undertaken to rescue markets and economies, most recently when Covid-19 shuttered large swathes of the global economy in 2020. Coinciding with the current outbreak in inflation, that could spur calls to rein in monetary policy makers’ independence, or limit what steps they can take in the next crisis.
“The problem with central bank losses are not the losses per se — they can always be recapitalized — but the political backlash central banks are likely to increasingly face,” said Jerome Haegeli, chief economist at Swiss Re, who previously worked at Switzerland’s central bank.
The following figures illustrate the scope of operating losses or mark-to-market balance-sheet losses now materializing:
- Fed remittances owed to the US Treasury reached a negative $5.3 billion as of Oct. 19 — a sharp contrast with the positive figures seen as recently as the end of August. A negative number amounts to an IOU that would be repaid via any future income.
- The Reserve Bank of Australia posted an accounting loss of A$36.7 billion ($23 billion) for the 12 months through June, leaving it with a A$12.4 billion negative-equity position.
- Dutch central bank Governor Klaas Knot, warned last month he expects cumulative losses of about 9 billion euro ($8.8 billion) for the coming years.
- The Swiss National Bank reported a loss of 95.2 billion francs ($95 billion) for the first six months of the year as the value of its foreign-exchange holdings slumped — the worst first-half performance since it was established in 1907.
While for a developing country, losses at the central bank can undermine confidence and contribute to a general exodus of capital, that sort of credibility challenge isn’t likely for a rich nation.
As Seth Carpenter, chief global economist for Morgan Stanley and a former US Treasury official put it: “The losses don’t have a material effect on their ability to conduct monetary policy in the near term.”
RBA Deputy Governor Michele Bullock said in response to a question last month about the Australian central bank’s negative-equity position that “we don’t believe that we are impacted at all in our capacity to operate.” After all, “we can create money. That’s what we did when we bought the bonds,” she noted.
But there can still be consequences. Central banks had already become politically charged institutions after, by their own admission, they failed to anticipate and act quickly against budding inflation over the past year or more. Incurring losses adds another magnet for criticism.
ECB Implications
For the European Central Bank, the potential for mounting losses comes after years of purchases of government bonds conducted despite the reservations of conservative officials arguing they blurred the lines between monetary and fiscal policy.
With inflation running at five times the ECB’s target, pressure is mounting to dispose of the bond holdings — a process called quantitative tightening that the ECB is currently preparing for even as the economic outlook darkens.
“Although there are no clear economic constraints to the central bank running losses, there is the possibility that these become more of a political constraint on the ECB,” Goldman Sachs Group Inc. economists George Cole and Simon Freycenet said. Particularly in northern Europe, it “may fuel the discussion of quantitative tightening.”
President Christine Lagarde hasn’t given any indication that the ECB’s decision on QT will be driven by the prospect of incurring losses. She told lawmakers in Brussels last month that generating profits isn’t part of central banks’ task, insisting that fighting inflation remains policymakers’ “only purpose.”
As for the Fed, Republicans have in the past voiced opposition to its practice of paying interest on surplus bank reserves. Congress granted that authority back in 2008 to help the Fed control interest rates. With the Fed now incurring losses, and the Republicans potentially taking control of at least one chamber of Congress in the November midterm elections, the debate may resurface.
The Fed’s turnaround could be particularly notable. After paying as much as $100 billion to the Treasury in 2021, it could face losses of more than $80 billion on an annual basis if policymakers raise rates by 75 basis points in November and 50 basis points in December — as markets anticipate — estimates Stephen Stanley, chief economist for Amherst Pierpont.
Without the income from the Fed, the Treasury then needs to sell more debt to the public to fund government spending.
“This may be too arcane to hit the public’s radar, but a populist could spin the story in a way that would not reflect well on the Fed,” Stanley wrote in a note to clients this month.
–With assistance from Garfield Reynolds.
©2022 Bloomberg L.P.