(Bloomberg) — Profits and losses are not usually considered a consideration for central banks, but the rapid rise in red ink at the Federal Reserve and many peers risks becoming more than just an accounting freak.
Most Read by Bloomberg
The bond market is facing its worst selloff in a generation, driven by high inflation and aggressive interest rate hikes that central banks are implementing. Falling bond prices, in turn, mean paper losses on the massive holdings the Fed and others amassed during their bailout efforts in recent years.
The rate hikes also include central banks paying more interest on reserves that commercial banks park with them. That drove the Fed into operating losses, creating a hole it may eventually require the Treasury Department to fill through debt sales. The UK Treasury is already preparing to offset 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 revenue. U.S. Treasuries will see a “stunning swing,” from taking about $100 billion last year from the Fed to a potential annual loss rate of $80 billion by the end of the year, according to Amherst Pierpont Securities LLC .
The accounting losses threaten to fuel criticism of asset purchase programs undertaken to rescue markets and economies, most recently when Covid-19 shut down large parts of the global economy in 2020. It coincides with the current burst of inflation, which could fuel calls to curb the independence of monetary policymakers or limit the steps they can take in the next crisis.
“The problem with central bank losses is not the losses themselves — they can always be recapitalized — but the political backlash that central banks are increasingly likely to face,” said Jerome Haegeli, chief economist at Swiss Re, who previously worked in Switzerland. Central bank.
The following figures illustrate the extent of operating losses or balance sheet losses from the market that are now materializing:
Fed remittances owed to US Treasuries hit a negative $5.3 billion on October 19 — a sharp contrast to the positive numbers seen through the end of August. A negative number constitutes an IOU that will be repaid through any future income.
The Reserve Bank of Australia posted an accounting loss of A$36.7 billion ($23 billion) for the 12 months to June, leaving it with a negative equity position of A$12.4 billion.
Dutch central bank governor Klaas Knot warned last month that he expects cumulative losses of around 9 billion euros ($8.8 billion) over the next few 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 fell – the worst first-half performance since it was founded in 1907.
While for a developing country, losses at the central bank can undermine confidence and contribute to a general capital exodus, this kind of credibility challenge is unlikely for a rich country.
As Seth Carpenter, global chief economist for Morgan Stanley and a former US Treasury official, said: “The losses don’t have a material effect on their ability to conduct monetary policy in the short term.”
RBA Deputy Governor Michele Bullock said in response to a question last month about the Australian central bank’s negative capital position that “we don’t believe we are at all impacted on 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 the inflation that had been rampant over the past year or so. Learning losses adds another magnet for criticism.
Implications of the ECB
For the European Central Bank, the potential for higher losses comes after years of government bond purchases carried out despite reservations from conservative officials who argued they blurred the lines between monetary and fiscal policy.
With inflation running at five times the ECB’s target, pressure is mounting to shed bond holdings — a process called quantitative easing that the ECB is currently preparing for even as the economic outlook darkens.
“While there are no clear economic limits to the central bank’s losses, there is the possibility that these will become more of a political constraint for the ECB,” said economists at Goldman Sachs Group Inc. George Cole and Simon Freycenet. In northern Europe in particular, it “could fuel the discussion of quantitative easing”.
President Christine Lagarde has given no indication that the ECB’s QT decision will be driven by the prospect of incurring losses. She told lawmakers in Brussels last month that generating profits is not part of central banks’ remit, insisting that fighting inflation remains “the sole aim of policymakers”.
As for the Fed, Republicans have in the past expressed opposition to its practice of paying interest on excess bank reserves. Congress granted that authority in 2008 to help the Fed control interest rates. With the Fed now suffering losses and Republicans likely to take control of at least one chamber of Congress in November’s midterm elections, the debate could resurface.
The Fed’s return may be particularly visible. After paying up to $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 predict — reviews Stephen Stanley, chief economist for Amherst Pierpont.
Without the income from the Fed, the Treasury must sell more debt to the public to finance government spending.
“This may be too arcane to hit the public’s radar, but a populist could paint 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.
Most Read from Bloomberg Businessweek
©2022 Bloomberg LP