Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Lose Money On Interest
Transcript
- Lucas: There is a persistent myth that central banks are these incredible cash cows, just printing money and sending billions back to the treasury every year. But if you look at the Federal Reserve’s latest financial statements, that narrative has completely flipped. For the first time in decades, the Fed is actually losing money on its operations, and it’s not because of bad investments. Luna: Right, it’s because they’re paying more to hold onto all that liquidity than they’re earning from the assets themselves. It’s a classic case of liabilities outpacing assets. Lucas: Exactly. To understand why this matters for your wallet, we have to talk about Interest on Reserves. The Fed pays commercial banks interest on the deposits they keep at the central bank. When interest rates were near zero, that cost was negligible. But now that the Fed Funds Rate is hovering around five percent, that bill has ballooned into something massive. Luna: So the Fed is essentially paying rent on money that isn’t even moving through the real economy? That seems like a huge inefficiency in the system. Lucas: It feels inefficient, but it’s a necessary tool for controlling inflation. By offering a high return on safe deposits, the Fed ensures that commercial banks don’t dump excess cash into risky loans or bonds that could spark overheating. But here is the catch: the Fed funds those payments by buying long-term Treasury bonds. And right now, the coupon payments on those bonds aren’t covering the interest expense on the reserves. Luna: That creates a structural deficit for the central bank. Does that undermine their credibility? If they’re losing money, do people stop trusting the dollar? Lucas: It doesn’t undermine the currency itself, because the Fed can always create more base money to cover the loss. But it does create a political friction. Historically, the Fed remitted hundreds of billions annually to the US Treasury. Now, they are reporting negative earnings, which means those transfers have stopped entirely. The Treasury is effectively subsidizing the Fed’s monetary policy with taxpayer dollars instead of receiving dividends. Luna: That is a really interesting inversion. Usually, we think of government spending as a drain on resources, but here the central bank’s policy decisions are creating a direct fiscal drag on the federal budget. Lucas: Let’s quantify it. In recent quarters, the Fed’s interest expense on reserves has exceeded one hundred billion dollars annually. Meanwhile, their income from mortgage-backed securities and Treasuries has been much lower due to the structure of their portfolio. So we are looking at a net loss that could approach forty or fifty billion dollars a year. That is real money leaving the federal coffers. Luna: Forty billion is not a rounding error. That’s enough to fund significant portions of domestic programs. How does the Fed account for this in their accounting books? Lucas: They record it as an asset called 'Deferred Asset'. Essentially, they say, 'we are losing money now, but once rates fall and our bond yields rise relative to reserve costs, we will recoup this.' It’s an IOU to the Treasury. They aren’t writing off the debt; they are deferring the payment. But until that happens, the Treasury sees no remittance. Luna: But if rates stay high for longer, that deferred asset could grow indefinitely. Is there a cap on how much debt the Fed can accumulate before it becomes a problem? Lucas: Technically, no. The Fed is not constrained by profitability in the same way a corporation is. However, there is a practical limit to the size of that deferred asset. If it gets too large, it complicates the Fed’s ability to shrink its balance sheet later. They might feel pressured to keep rates higher to generate more income, which would conflict with their inflation-fighting mandate. Luna: So they are trapped. If they cut rates to help the Treasury, inflation might rebound. If they keep rates high to save their own balance sheet, they hurt the broader economy. It’s a lose-lose scenario for policymakers. Lucas: Precisely. And this dynamic highlights the growing entanglement of monetary and fiscal policy. When the central bank loses money, it’s no longer a neutral observer. It becomes a stakeholder in the national debt. The distinction between the Treasury and the Fed blurs when the Fed is essentially borrowing from the Treasury to pay banks. Luna: Does this affect ordinary consumers? I mean, beyond the abstract notion of government budgets, does this change anything about my mortgage or savings rate? Lucas: Indirectly, yes. If the Treasury needs to borrow more to cover the lack of Fed remittances, it increases the supply of new bonds. An increased supply of bonds can push yields up, which keeps borrowing costs high for everyone else. So your mortgage rate might stay sticky even if the Fed hints at cutting the Fed Funds Rate. Luna: That’s a crucial link. People think the Fed controls all rates, but the Treasury’s financing needs are also driving the yield curve. It’s a two-headed monster. Lucas: Two-headed indeed. Another consequence is the potential for political pressure. Congress has already started questioning the Fed’s independence over these losses. Lawmakers are asking why the central bank is 'wasting' money. This politicization could force the Fed to prioritize balance sheet health over price stability, which would be dangerous. Luna: I can see why politicians would hate that. It gives them a convenient target to blame for fiscal shortfalls without having to make tough spending choices. It’s a scapegoat mechanism. Lucas: Spot on. And let’s not forget that this isn’t just a US phenomenon. The European Central Bank and the Bank of England are dealing with similar dynamics, though the scale differs because their balance sheets are smaller relative to GDP. The US experience is the canary in the coal mine for advanced economies. Luna: So we are witnessing a structural shift in how central banks operate. They used to be profit machines; now they are cost centers. How should investors adjust their expectations given this new reality? Lucas: Investors should assume that the era of free money from the Fed is over. More importantly, they should recognize that the Fed has less flexibility to act as a lender of last resort or stimulate growth if its balance sheet is under political scrutiny. The margin for error has shrunk significantly. Luna: That changes the risk profile of fixed income investments. If the Fed can’t easily expand its balance sheet without backlash, volatility might increase during stress events. Lucas: Exactly. Markets used to bet on the Fed putting a floor under asset prices. Now, that floor is less certain because the Fed is incentivized to shrink its holdings to reduce its interest expenses. Every bond sale reduces the balance sheet, which takes liquidity out of the system. Luna: So the very action the Fed takes to fix its own books—selling bonds or letting them mature—tightens financial conditions. It’s an unintended contractionary effect baked into their recovery plan. Lucas: That is the irony. To get back to normal, they have to do something that feels like tightening. It’s a paradox that keeps economists up at night. We call it 'Quantitative Tightening', but really it’s just 'Loss Minimization'. Luna: I love that term. Loss Minimization. It sounds less heroic than Quantitative Tightening. It makes it clear that the Fed is acting out of self-preservation rather than macroeconomic stewardship. Lucas: Self-preservation of institutional integrity, anyway. Because remember, the deferred asset will eventually be paid back. Once rates normalize, the Fed will likely remit hundreds of billions in a lump sum to catch up. But that lump sum is years away, and in the meantime, the Treasury bears the cost. Luna: It really forces us to rethink who is funding whom. We always think taxpayers fund the government, but here, the government is indirectly funding the central bank’s monetary policy decisions. Lucas: And that leads us to a broader question about the future of central banking. If this model is unsustainable, will we see a return to quantitative easing as a permanent fixture? Or will central banks start paying interest only on required reserves, ignoring excess reserves entirely? Luna: If they ignore excess reserves, they lose control of the overnight rate. Banks would just park money elsewhere. So they are stuck with the current system unless they radically change how they manage liquidity. Lucas: Which brings us back to the present moment. As we navigate this quarter, keep an eye on the Fed’s quarterly financial report. Watch that deferred asset line item. It is becoming one of the most important numbers in global finance, even if it rarely makes headlines. Luna: It’s a quiet crisis, but a massive one. Thanks for breaking that down, Lucas. It really puts the 'cost' of low inflation into perspective. Lucas: Anytime. It’s a reminder that every policy choice has a price tag, and sometimes the bill comes due in ways we don’t expect. Luna: If walking through the economy with us has made something click, consider supporting the show directly. We run ad-free, and listener contributions are literally what allow us to produce these deep dives every single day. Lucas: You can join the community of supporters by going to buy me a coffee dot com slash fexingo. It helps keep the lights on and the research sharp, so we can keep bringing you these conversations. Luna: We appreciate every bit of support, and it lets us focus on the substance rather than the clicks. Lucas: Thanks for listening. Next time you hear about interest rates, ask yourself: who is actually paying for them?