Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Lose Money On Interest
Transcript
- Lucas: Look at the Federal Reserve’s latest financial statements. They’re reporting a net operating loss of roughly seventy billion dollars this year alone. That is not a typo. That is the central bank of the United States losing more money in twelve months than almost any Fortune 500 company makes in a decade. Luna: Seventy billion? I know they pay interest on those reserves, but that number feels like it should be impossible. How does an entity that creates money lose money? Lucas: It’s simple arithmetic, Luna. The Fed bought trillions of dollars in Treasury bonds and mortgage-backed securities during the pandemic at near-zero yields. Now, to keep inflation anchored, they are paying banks roughly four point five percent interest on the reserves sitting in their accounts at the Fed. The cost of funding those reserves now exceeds the income generated by the low-yielding assets they hold. Luna: So they are essentially paying out more cash to commercial banks than the bonds they own are paying them in interest. That is an inverted float situation on a national scale. Lucas: Exactly. And historically, the Fed remitted all excess profits to the U.S. Treasury. This year, because they are operating at a loss, they remit zero. In fact, they accumulate deferred assets—a tab they owe the Treasury that will only grow if rates stay where they are. It’s a structural reversal of thirty years of fiscal dominance. Luna: Does this actually change their ability to raise or lower rates? Or is it just a accounting curiosity for economists? Lucas: Most policymakers say it doesn’t change the mechanics of monetary policy. The Fed can always create reserves to pay interest. But it changes the political economy of it entirely. When the central bank stops sending checks to Washington, Congress starts looking at them with less sympathy and more scrutiny. Luna: You mean politicians who have been complaining about the deficit suddenly care about the Fed's bottom line? Lucas: Precisely. For decades, the Fed was viewed as a piggy bank for the government. Now, they are a drain on it. That shifts the leverage. If you are a senator arguing for spending cuts, you can point to the Fed’s losses as evidence that the entire federal budget is mismanaged. It gives critics a new weapon against central bank independence. Luna: I remember reading about the ECB doing something similar. Are other central banks bleeding money too? Lucas: The European Central Bank has been running losses since last year. The Bank of Japan has been in negative equity for years due to their yield curve control policies. But the U.S. case is unique because of the dollar’s reserve status. The Fed’s losses are being watched globally as a signal of American fiscal stress. Luna: Wait, before we dive deeper into the political fallout, if today’s breakdown of the Fed’s balance sheet helped make sense of the markets, consider supporting the show. We stay ad-free so we can dig into these details without advertisers influencing the narrative. You can buy me a coffee dot com slash fexingo. Lucas: Yeah, exactly. If this kind of deep-dive into the mechanics of money helps you navigate your own finances, listener support is the only way we keep producing it. No ads, no compromises. Just buy me a coffee dot com slash fexingo. Luna: It really does help to hear the logic laid out clearly. Thanks for keeping the feed clean and focused. Lucas: Back to the political angle. The real danger isn’t the accounting loss itself; it’s the erosion of perceived legitimacy. When the Fed loses money, it looks inefficient. Even though it’s a policy choice, not a management failure, optics matter in governance. Luna: But isn’t the alternative worse? If they stop paying interest on reserves, won’t that destabilize the banking system? Lucas: That is the exact dilemma. If the Fed cuts the interest rate on reserves to zero to stop the bleeding, banks might pull their deposits out. They would move that cash into private market instruments, driving up short-term rates anyway. So the Fed is trapped. They must pay high rates to maintain control over the federal funds rate, which guarantees they will lose money. Luna: So they are choosing monetary control over fiscal generosity. That seems like a principled stand, but it comes at a cost. Lucas: It is principled, but it’s also isolating. Look at the timeline. In 2021, the Fed remitted forty-seven billion dollars to the Treasury. Today, they send nothing. Next year, if rates stay elevated, they might start accumulating a deferred asset liability. Eventually, they will have to pay back the Treasury once they return to profitability, which could take a decade. Luna: A decade of zero remittances is a huge hit to the federal budget. Does that force the Treasury to issue more debt to cover the shortfall? Lucas: It adds pressure. The Treasury is already issuing record amounts of debt to fund the deficit. Losing the Fed’s surplus means the Treasury has to find buyers for every single new bond issued. It tightens the fiscal environment even if monetary policy remains loose. Luna: So the Fed’s losses are effectively a hidden tax on the government, passed through to the public via higher borrowing costs. Lucas: That’s a fair way to put it. It’s not a direct tax, but it removes a source of non-debt financing. The government has to borrow more to do the same amount of work. That pushes yields up, which hurts everyone from homeowners to corporations. Luna: I’m curious about the banking sector’s role here. Do banks actually want the Fed to pay high interest on reserves? Lucas: They love it. Commercial banks are sitting on hundreds of billions in reserves. Earning four point five percent risk-free is better than lending it out at three percent. It’s a free lunch for the banking sector, funded by the rest of the economy through the Fed’s losses. Luna: That sounds like a transfer of wealth from taxpayers to large financial institutions. Is there any pushback from smaller banks? Lucas: Smaller banks don’t hold as many reserves. They rely more on loans. So the high interest on reserves distorts the yield curve for them, making lending less attractive relative to parking cash at the Fed. It actually discourages credit creation, which is the opposite of what we wanted in a recovery. Luna: So the policy meant to stabilize prices is inadvertently tightening credit conditions for small businesses. That’s a secondary effect most people miss. Lucas: Exactly. The primary goal is inflation control. The side effect is a distorted banking landscape. And now, with the Fed losing money, that distortion is becoming politically unsustainable. We are seeing more calls from lawmakers to reform how the Fed manages its balance sheet. Luna: Reform how? By selling off the bonds? Lucas: Not yet. Selling bonds now would crash the market. The plan is to let them mature naturally. But the longer they hold, the larger the accumulated loss becomes. It’s a slow burn. The question is whether the Fed can wait out the high-rate environment without losing credibility. Luna: If they lose credibility, does that mean markets start doubting their inflation targets again? Lucas: That is the risk. If the Fed is seen as financially insolvent or politically compromised, their forward guidance loses weight. Markets might think they will be forced to print money to cover losses, which reignites inflation fears. It’s a vicious cycle. Luna: Print money to cover losses? Isn’t that what they did during the pandemic? Lucas: Technically, yes. They created reserves to buy assets. But covering ongoing operational losses with newly created money is different from buying bonds. It’s direct monetization of the deficit. That is the red line most central bankers try to avoid. Luna: So the seventy billion dollar loss is a warning shot across the bow of central bank orthodoxy. Lucas: It’s a wake-up call. The era of easy money is over, but the era of profitable central banking might be over too. We are entering a period where monetary policy has a much higher fiscal price tag. Luna: And we need to watch how politicians react to that bill coming due. Lucas: Absolutely. The next time you hear about a debate on government spending, remember that the Fed is no longer helping to pay the tab. They are adding to it. The dynamics have fundamentally shifted. Luna: It’s a subtle shift in the numbers, but a massive shift in the power structure. Lucas: Right. And for anyone trying to predict market moves, understanding that the Fed is now a net borrower from a fiscal perspective changes how you view their incentives. They might be slower to cut rates, not just because of inflation, but because cutting rates reduces their revenue further. Luna: So higher rates help the Fed’s books, even if they hurt the economy. A classic catch-22. Lucas: A perfect one. The institution designed to serve the public is now financially incentivized to keep rates high. Whether that serves the long-term health of the currency is the question we will be watching closely in the coming quarters.