How Fed balance sheet losses impact taxpayers

As interest rates continue to rise, does the Fed have a balance sheet problem? Judge Glock, Manhattan Institute Senior Fellow and Director of Research, joins Yahoo Finance Live to discuss how the Fed's growing balance sheet may impact taxpayers.

Video transcript

[AUDIO LOGO]

JULIE HYMAN: Well, everyone is mostly focused on interest rates and the possibility of more tightening in the coming months from the Federal Reserve. Not much attention is being paid to the central banks' balance sheet. The Fed went from having less than trillion dollars on its balance sheet before 2008 to 4 and a half trillion in the Tens to almost 9 trillion after the pandemic.

And as interest rates continue to rise as is forecasted, this could keep getting worse. Here's what this means for the Fed and taxpayers. More on this is Judge Glock, a Manhattan Institute senior fellow and director of research. So Judge, how should we think about the Fed's balance sheet here and the effect of its recent policy moves on it?

JUDGE GLOCK: Yeah, so a lot of people forget the Federal Reserve banks are also banks. They act like other banks, and that they borrow money, and then they lend it out again. Most of that borrowing is from their member banks. They deposit their reserves with the Federal Reserve. And then the Federal Reserve lends that money usually by buying out government bonds or mortgage securities.

That hasn't been a problem historically because the Fed had usually didn't pay any money really for those reserves. But since the pandemic, they have interest on reserves, those banks that keep the money at the Federal Reserve itself. And now whenever the Fed raises interest rates, we hear a lot about the federal funds rate.

But the real important interest rate is that interest on reserve rates. And so the Federal Reserve is right now paying about 5.15% to all the banks that lend money to the Federal Reserve itself. The real problem is that's more money than the Federal Reserve is getting on its assets, all those Treasury and mortgage backed security bonds they bought over the past 10, 15 years. And that's going to be a problem for the taxpayer and maybe even the Federal Reserve itself.

AKIKO FUJITA: So how effective has the tightening of that balance sheet been?

JUDGE GLOCK: Well, it's had a real effect. So according to the most recent Federal Reserve release, the Federal Reserve has lost about $65 billion over the past eight months. That's not chump change. The Federal Reserve again pays about 5.15% in interest. All those mortgage backed bonds and treasury bonds they bought during the pandemic even during the financial crisis, those pay about 2 and 1/2%. So not too dissimilar from the sort of problems you saw at places like Silicon Valley Bank, at First Republic and others. They were borrowing short, lending long. And then when those interest rates inverted, you started to see a lot of problems in their balance sheet.

JULIE HYMAN: But what are the implications here for the Fed? I mean, the Fed is not going out of business.

JUDGE GLOCK: No, no, the Fed can always print its own budget. And that's a nice advantage for the Fed to have. But there are political consequences for this as well as for the taxpayers. So about 10 years ago, Jerome Powell himself, when he was just a Federal Reserve Board member, said-- realized what would happen if they kept buying all these securities and interest rates went up, that the Fed would start losing money.

He said, well, what happens if we're paying billions of a year in interest rates to big banks and not giving any money to the taxpayer at a time of fiscal austerity? That's going to look bad politically. And that is exactly what's happened. So again, it's about $65 billion they've lost directly over the last nine months or so.

If you do a mark to market accounting on their bank balance sheet-- again, Similar to what people have talked about for Silicon Valley Bank-- you're looking at losses about a trillion dollars. This is significant. And somebody somewhere has to pay that. And what that means is the taxpayer is going to have to pay that.

They're not going to get the income from the Federal Reserve. The Federal Reserve says it won't be giving money back to the Treasury maybe for up to a decade. That might make some Congress members, especially during a time of fiscal austerity and tightening a little bit angry.

JULIE HYMAN: And then let's talk about the flip side of this, which is it is enormous, but they are starting to shrink that balance sheet as a part of their tightening. How should we be thinking about that as a tightening instrument versus interest rate increases, right? Because we know they paused, but they're still winding down the balance sheet. That is still happening.

JUDGE GLOCK: Yeah. So obviously if you saw that chart that you showed to your viewers earlier, you've seen a very slight decrease in their balance sheet since the peak in around 2021. But what you also saw is that when you had a little crisis, the Silicon Valley Bank crisis, they increased that balance sheet again. And it's only started to dip down again.

And this is the tradition of what we've seen for the past 15 years. You've seen a very gradual attempt to wind down that balance sheet. Again, you see that after 2016 or so on that balance sheet. And then when the next crisis hits, it bumps right back up again. I think that's what we're going to continue to see until the Federal Reserve takes a very different path. If they keep increasing the balance sheet by hundreds of billions of dollars or trillions of dollars every time there's a crisis, we're never going to get that back down to a more normal level, which is hopefully what we all want to get, where the Federal Reserve is not giving so much credit to the economy, not deciding where certain credit goes in the economy, and so forth. We want a Federal Reserve that's acting more sort of neutrally across the entire economy, which is not what they're doing right now.

AKIKO FUJITA: So I mean, what do you see as sort of the path forward? I mean, to your point, we're talking so much about the rates here. Obviously the balance sheet tightening is part of that. How effective can that be moving forward, if we're still pause come July and those rate hikes don't take shape or the additional rate hikes don't take shape until later this year?

JUDGE GLOCK: Well, the balance sheet tightening will have a small effect. The rates are the most important part of it. Because like I said, when the banks keep that money at the Federal Reserve, and they're telling banks how much money they're going to get for keeping that, that determines how fast the banks are going to spend their reserves on the balance sheet. So I think the more important part of than sort of tightening for the overall economy is the sort of credit allocation question that the Federal Reserve faces.

A significant part trillions of the Fed balance sheet are these mortgage backed securities. That's the Federal Reserve itself deciding where certain money in the economy should go. And the larger the balance sheet is, the more of a temptation it is for politicians, for others to claim, hey, we need you to fund this sector, we need you to fund this sector.

You saw that during the pandemic. The Fed still has tens of billions of dollars of municipal debt on its balance sheet. It still has billions of the Main Street loans that were authorized in the pandemic. That large balance sheet really kind of looks like a honeypot to a lot of politicians. And it's a danger that they're going to take advantage of that unless they start tightening or start reducing that. And we've seen no significant indication they've been doing that over the past 15 years.

AKIKO FUJITA: Judge Glock, Manhattan Institute senior fellow and director of research. Good to have you on today.

JUDGE GLOCK: Thank you so much for having me.