The powerful and prestigious Federal Reserve is having a tough year in 2022 in at least three ways:
- It has failed with inflation forecasting and performance;
- It has giant mark-to-market losses in its own investments and looming operating losses;
- It is under political pressure to do things it should not be doing and that should not be done at all.
Forecasting inflation
As everybody knows, the Fed’s overoptimistic inflation forecasts for the runaway inflation year of 2021 were deeply embarrassing. Then the Fed did it again for 2022, with another wide miss. In December 2021, it projected 2022 Personal Consumption Expenditures inflation at 2.6%, while the reality through June was 6.8%, with Consumer Price Index inflation much higher than that. It would be hard to give the Fed anything other than a failing grade in its supposed area of expertise.
The Fed’s interest rate forecast for 2022 was three federal funds target rate increases of 0.25%, so that its target rate would reach 0.9% by the end of 2022. It forecast the rate at 2% by the end of 2024. Instead, by July 2022, it already reached 2.5%.
In short, the Federal Reserve cannot reliably forecast economic outcomes, or what the results of its own actions will be, or even what its own actions will be. Of course, neither can anybody else.
It is essential to understand that we cannot expect any special economic or financial insight from the Federal Reserve. This is not because of any lack of intelligence or diligence, or not having enough computers or PhDs on the payroll, but of the fundamental and inevitable uncertainty of the economic and financial future. Like everybody else, the Fed has to make decisions in spite of this, so it will unavoidably make mistakes.
We should recall how Ben Bernanke, then Chairman of the Federal Reserve, accurately described his extended ‘QE’ strategy in 2012 as “a shot in the proverbial dark”. That was an honest admission, although unfortunately he admitted it only within the Fed, not to the public.
The Governor of the Reserve Bank of Australia (their central bank) described the bank’s recent inflation forecasting errors as “embarrassing”. Such a confession would also be becoming in the Federal Reserve, especially when the mistakes have been so obvious. The current fed funds rate of 2.5% may sound high today, if you have become used to short-term rates near zero and you have no financial memory. But it is historically low, and as many have pointed out, it is extremely low in real terms. Compared to CPI inflation of 8.5%, it is a real interest rate of negative 6%.
Savers will be glad to be able to have the available interest rates on their savings rise from 0.1% to over 2%, but they are still rapidly losing purchasing power and having their savings effectively expropriated by the government’s inflation.
Although in July and August 2022 (as I write), securities prices have rallied from their lows, the 2022 increases in interest rates have let substantial air out of the Everything Bubble in stocks, speculative stocks in particular, SPACs, bonds, houses, mortgages, and cryptocurrencies that the Fed and its fellow central banks so assiduously and so recklessly inflated.
A mark-to-market insolvent Fed
Nowhere are shrunken asset prices more apparent than in the Fed’s own hyper-leveraged balance sheet, which runs at a ratio of assets to equity of more than 200. As of 31 March 2022, the Fed disclosed, deep in its financial statement footnotes, a net mark-to-market (MTM) loss of $330bn on its investments. Since then, the interest rates on 5 and 10-year Treasury notes are up about an additional one-half percent. With an estimated duration of 5 years on the Fed’s $8tr of long-term fixed rate investments in Treasury and mortgage securities, this implies an additional loss of about $200bn in round numbers, bringing the Fed’s total MTM loss to over $500bn.
Compare this $500bn loss to the Fed’s total capital of $41bn. The loss is 12 times the Fed’s total capital, rendering the Fed technically insolvent on a mark-to-market basis. Does a MTM insolvency matter for a fiat currency-printing central bank? An interesting question – most economists argue such insolvency is not important, no matter how large. What do you think, candid Reader?
The Fed’s first defense of its huge MTM loss is that the loss is unrealised, so if it hangs on to the securities long enough it will eventually be paid at par. This would be a stronger argument in an unleveraged balance sheet, which did not have the Fed’s $5tr of floating rate liabilities. With the Fed’s leverage, however, the unrealized losses suggest that it has operating losses to come, if the higher short-term interest rates implied by current market prices come to pass.
