Not inflation, but Fed's own deteriorating balance sheet should hasten a rate cut

While the Street and economists have been fixated on job and consumer inflation data to get a sense of when the Fed is likely to cut interest rates, the one indicator that is already flashing red is the US Federal Reserve’s own balance sheet.

The just released 110th annual report of the board of governors of the Federal Reserve System shows the regulator has ended 2023 with a negative earnings remittance of $114 billion, which effectively means the Fed owes this amount in future remittances owing to the gap between its income and expenses. Against a surplus of $59.4 billion in 2022, which represents the excess income that the Fed transferred to the Treasury, the final net earnings remittance was recorded at −$116.1 billion.

This extraordinary situation arises from the Fed's aggressive interest rate hikes aimed at curbing inflation. While these hikes were necessary to bring down consumer price inflation, they come with significant side effects. The Fed’s liabilities, particularly in the form of interest payments on reserves held by commercial banks, have increased significantly. At the same time, a majority of the securities held by the Fed were purchased during periods of low interest rates, especially during the Fed’s quantitative easing (QE) phase, resulting in lower returns on these assets. Since these securities were acquired when interest rates were low, their coupon payments (interest payment on the bonds) are fixed at lower rates.

This mismatch between rising liabilities and stagnant income is starkly reflected in the Fed’s financial results. The sharp drop in income from $128 billion in 2022 to nearly $60 billion in 2023 indicates a significant decrease in the revenue generated from SOMA holdings. The Federal Reserve Bank of New York, on behalf of the Reserve Banks, holds in the SOMA the resulting securities, which include U.S. treasuries, federal agency and government-sponsored enterprise debt securities, federal agency and government-sponsored enterprise mortgage-backed securities, investments denominated in foreign currencies, and commitments to buy or sell related securities. These securities yield relatively low returns compared to the higher rates now being paid on reserves.

The $116 billion deficit is the first time in years that the Fed has had to record a negative remittance to the U.S. treasury.

The implications of this negative remittance are profound.

For one, it exacerbates the federal budget deficit, as the treasury misses out on a reliable source of revenue. The U.S. government’s budget deficit has already hit a record $244 billion in July, a y-o-y increase of $23 billion over the $221 billion deficit seen in July 2023.

More importantly, it potentially limits the Fed’s ability to maintain its current monetary policy trajectory. As the financial burden of higher interest rates becomes more apparent, the Fed may be forced to reconsider its strategy.

While the primary narrative around interest rate cuts often centres on economic slowdown or inflation control, the Fed’s balance sheet pressures could become a significant driver. If the Fed stays hawkish without addressing the growing imbalance, it risks further financial strain, which could ultimately undermine its operational independence and policy flexibility.

The Fed began raising interest rates to slow down inflation, implementing 11 rate hikes between March 2022 and July 2023, as a result the benchmark rate is now at a 22-year high of 5.25%-5.50%. Although inflation has moderated to around 3%, it's still above the Fed’s 2% target and slightly down from 3.3% in May.

In the short term, the Fed’s focus remains on controlling inflation, but the mounting losses indicate that an inflection point is nearing. The necessity of preserving the Fed's financial health may soon align with broader economic conditions that warrant lower interest rates, making a rate cut not just likely, but inevitable.

Though, technically, the Fed - with a $7.95 trillion balance sheet - can never go bankrupt, symbolically, it has.