Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Fund Their Own Operations
Transcript
- Lucas: If walking through the economy with us has made something click, remember that listener support is what keeps these shows ad-free and running daily. Lucas: A couple of dollars a month is genuinely what keeps these going, so if you've gotten something out of them, check out buy me a coffee dot com slash fexingo. Luna: Thanks for that, Lucas. It really does help keep the research sharp. Luna: Now, let's get back to the plumbing. Most listeners think central banks are just magic money printers, but I want to talk about the actual bill they have to pay to keep the lights on. Lucas: Right, and that’s where the public perception diverges sharply from operational reality. We often hear about quantitative easing or rate hikes as if they’re abstract levers pulled in a vacuum, but every single one of those actions lands on a balance sheet that has to be balanced, funded, and managed. Lucas: The specific angle we’re drilling into today is not how central banks create money for the broader economy, but how they finance their own existence and whether that financing model compromises their independence. Luna: So you’re saying the Federal Reserve, or the European Central Bank, actually has an expense report? Lucas: Exactly. They have offices, staff, technology infrastructure, and yes, they have to pay interest on the reserves banks hold at the Fed. And here is the concrete detail most people miss: the central bank doesn’t get its budget from Congress or Parliament. Lucas: It funds itself entirely through the spread between what it earns on assets, mostly U.S. Treasury bonds and mortgage-backed securities, and what it pays out in interest on bank reserves. If that spread goes negative, the institution starts losing money on paper, which sounds terrifying but is actually quite normal in certain economic environments. Luna: Wait, losing money? Doesn’t that threaten their ability to operate? Like, do they run out of cash? Lucas: No, because central banks cannot go bankrupt in the traditional sense. They can always create liquidity to meet obligations. The issue isn’t solvency; it’s legitimacy and political pressure. When the Fed reports a net loss for the year, it sends zero dividends to the Treasury, which means the government has to cover its own deficit with debt instead of getting that windfall. Luna: That sounds like a political problem, not a banking problem. Why does it matter if the Treasury gets less money? Lucas: It matters because it fuels the narrative that central bankers are reckless or unaccountable. Critics point to negative net income as evidence that monetary policy is too loose or poorly managed, even though the loss is purely an accounting artifact of rising interest rates against older, low-yielding assets. Luna: So the loss is real on paper, but they don’t actually spend more? They just keep the books in the red? Lucas: Precisely. They defer the payment to the Treasury. The Fed holds onto earnings until future profits exceed past losses, then resumes sending checks to Washington. It’s called deferred assets, and it can sit there for years, sometimes decades, depending on the yield curve. Luna: I remember reading about this during the post-pandemic inflation surge. The Fed had billions in losses. Did that change how they set rates? Lucas: Structurally, no. The mandate is price stability and maximum employment, not profit maximization. But politically, it adds friction. When the Fed raises rates to fight inflation, it also increases its own interest expense, which deepens the net loss. So the very tool needed to stabilize the economy exacerbates the accounting deficit. Luna: That feels counterintuitive. Raising rates fixes inflation but hurts their bottom line further? Lucas: It’s a double-edged sword. Higher rates slow the economy, which helps inflation, but it also means the Fed pays more interest to commercial banks for holding their reserves. Since the reserve balance is massive—hundreds of billions—it becomes a significant line item. Luna: Okay, so let’s talk about that number. How big is the reserve balance right now in September 2026? Lucas: It hovers around the two trillion dollar mark globally across major central banks, with the U.S. segment sitting near twelve hundred billion dollars. That is a lot of money sitting idle, earning nothing for the banks but costing the Fed dearly in interest payments. Luna: Twelve hundred billion. And they’re paying maybe five percent on all of that? That’s sixty billion a year just in interest expense. Lucas: You’re close. It varies by instrument, but yes, the expense is enormous. Meanwhile, the assets they bought during quantitative easing—those ten-year Treasuries—are yielding similar rates now, so the spread is razor-thin or negative. That’s the squeeze. Luna: So they’re essentially breaking even or losing money on the trade they initiated years ago? Lucas: Correct. And this brings us to the core question of central bank independence. If a central bank is constantly telling the government, we can’t send you dividend money this year because our operations are underwater, does that weaken their hand? Luna: It might make politicians angrier. If I’m a senator seeing the Fed lose money while raising rates, I might ask why they aren’t managing their portfolio better. Lucas: Exactly. And some lawmakers have proposed tying central bank remuneration to congressional approval or forcing asset sales at a loss. That would be disastrous because selling assets at a loss crystallizes the deficit and removes the deferred asset buffer. Luna: Why would removing the buffer be bad? Isn’t clearing the debt good? Lucas: Because it forces the central bank to raise interest rates faster or sell bonds into a falling market, both of which could destabilize financial conditions. The deferred asset account acts as a shock absorber, allowing the Fed to maintain policy stability despite accounting volatility. Luna: So keeping the loss on the books is actually a feature, not a bug? Lucas: For operational continuity, yes. It decouples monetary policy from immediate fiscal constraints. The Fed doesn’t need to worry about its quarterly P&L statement to decide if it should hike rates or cut them. Luna: That’s a relief. I thought they were stressed about being poor. Lucas: They aren’t poor; they’re illiquid in terms of distributable cash, but solvent in every meaningful way. The real stress comes from the communication challenge. Explaining to the public why they are losing money while trying to convince them that inflation is under control is a tough tightrope. Luna: And if they mess up the communication, people start thinking the system is rigged. Lucas: Which leads us to the second part of this episode: how central banks manage expectations around their own finances. We’ve seen a shift toward greater transparency, publishing detailed monthly financial statements. Luna: Does that help? Or does it just give critics more ammunition? Lucas: It depends on who you ask. For economists, it provides data to model policy impacts. For the general public, it often just highlights the headline number: net loss of forty billion dollars. Without context, that looks like failure. Luna: But it’s not failure. It’s just math. You bought bonds at three percent, now you pay four percent. Lucas: Exactly. It’s a timing mismatch. The Fed holds long-duration assets while paying short-term rates on reserves. When the yield curve inverts, which it often does during tightening cycles, the margin collapses. Luna: So the inversion itself causes the loss. Interesting. I never connected those two dots. Lucas: It’s a structural feature of modern monetary policy. As central banks expanded their balance sheets, they took on more duration risk. When rates rise, that risk becomes expensive. It’s the cost of doing business in a high-rate environment after a decade of low rates. Luna: Do you think they’ll ever go back to sending big dividends to the Treasury? Lucas: Eventually, once the deferred asset account is cleared. But given current fiscal deficits, the Treasury probably doesn’t want the cash as much as it wants the Fed to stay independent. A profitable Fed that prints money to fund government spending is a recipe for hyperinflation fears. Luna: So the loss is actually a safeguard against fiscal dominance? Lucas: In a twisted way, yes. It reminds everyone that monetary policy is distinct from fiscal policy. The Fed isn’t a piggy bank for the government. Its job is stability, not revenue generation. Luna: I guess that’s the lesson here. Don’t judge a central bank by its profit margin. Lucas: Precisely. Judge it by its ability to anchor expectations and manage liquidity. The balance sheet is just the tool, not the goal. And understanding that distinction is crucial for anyone following the macro landscape this quarter. Luna: So next time you see a headline about Fed losses, just remember: it’s just accounting noise, not a signal of systemic collapse. Lucas: Right. The numbers look scary, but the machinery keeps turning regardless of the bottom line. That’s the beauty—and the frustration—of central banking.