THE OVERLOOKED THREAT TO THE FED`S MISSION / PROJECT SYNDICATE

The Overlooked Threat to the Fed’s Mission

It might come as a surprise to many to learn that the US Treasury is not required to recapitalize the Federal Reserve even if the central bank’s losses could prevent it from making its contractual payments or effectively pursuing its policy mandates. Unfortunately, this vulnerability has begun to matter more than it once did.

Willem H. Buiter and Anne C. Sibert

RALEIGH, NORTH CAROLINA – The relationship between the US Federal Reserve and the executive branch has been a major news topic, and not only because President Donald Trump recently announced Kevin Warsh’s nomination to succeed Jerome Powell as the next Fed chair. 

The current administration has also threatened Powell with a criminal indictment and tried to fire Fed Governor Lisa Cook on similar grounds. 

Understandably, many are wondering just how far Trump might go to undermine the Fed’s operational independence.

But another crucial aspect of the relationship between the central bank and the executive branch has been overlooked – and not just in the United States. 

Even if the central bank is operationally independent, the profit-and-loss-sharing arrangements between it and the Treasury – its beneficial owner – are often asymmetric. 

The Fed is required by law to pay its positive net operating profits into the Treasury’s general fund; but if the Fed incurs a loss, the Treasury is not required to compensate it (though the Fed can offset the loss against future remittances to the Treasury, if these are large enough, and there are limited exceptions for certain emergency funding facilities).

In other words, the Treasury is not required to recapitalize the Fed even if the latter’s losses could prevent it from making its contractual payments or effectively pursuing its monetary-policy and financial-stability mandates. 

Unfortunately, this has begun to matter more than it once did.

The problem starts with the fact that the Fed’s recorded capital, the difference between its assets (mainly Treasuries and mortgage-backed securities) and its contractual liabilities, is an imperfect measure of actual capital, because the Fed values its assets at amortized cost rather than market value. 

A better measure, what we call the true measure, would be capital plus accumulated unrealized gains on the assets, since this captures the difference between the market value and amortized cost.

Under the current arrangement, the Fed can offset accumulated operating losses that reduce its capital below some threshold level, currently around $40-46 billion, before paying the Treasury. 

It records an operating loss by debiting an asset account, and if it subsequently makes a profit, it credits that “deferred-assets” account until it returns to zero, at which point transfers to the Treasury resume.

This accounting device is similar to a firm’s recording of a loss as a deferred asset if it can be used to reduce subsequent tax obligations. 

Confusingly, though, another balance-sheet presentation on the Fed’s website shows a loss that would lower its capital below the threshold level being recorded as a debit to a negative liability account. 

Since such accounts are more typically used for overpayments and accounting errors, we prefer to view deferred assets as an asset account.

Thinking of the Fed’s losses as generating an asset requires one to believe that the deferred-assets account will eventually be fully amortized; that the Fed will, at some point, make new cumulative operating profits greater than its accumulated losses. 

So, after taking the arrangement with the Treasury into account, we would cautiously redefine true capital as the sum of recorded capital, accumulated unrealized capital gains, and the balance in the deferred-assets account.

As interest rates have increased, the Fed’s interest expense on depository institutions’ reserve balances and on securities sold under repurchase agreements has exceeded the fixed-income interest on its security holdings. 

It has run substantial operating losses, and the balance in the deferred-assets account has increased. 

Moreover, the Fed has also realized losses when it sold securities at less than historical cost, and it still has a significant unrealized loss in the form of a gap between the market and amortized values of its assets.

Through 2021 (see table), the deferred-assets account had a balance of zero, and there were positive cumulative unrealized capital gains. 

With its true capital positive, it remitted its net profits to the Treasury. 

But since then, the deferred-assets account has had a positive balance, reflecting negative operating profits and some realized losses.

There are also huge cumulative unrealized capital losses. 

True capital fell to a low of around -$1.35 trillion in 2023 and -$1.09 trillion in 2025. 

This number is significant. 

The International Monetary Fund estimates that US GDP was $30.6 trillion in 2025, meaning the Fed’s true capital in 2025 was -3.6% of GDP.

If the Fed continues to run losses, it may have still more negative true capital, even though two accounting sleights of hand allow it to avoid recording it. 

True, negative true capital is less problematic for the Fed than for a business. 

Roughly one-third of the Fed’s liabilities are Federal Reserve Notes (unbacked fiat money that is not a liability in any meaningful sense), and the same is true for deposits at the Fed, which account for half its liabilities. 

Moreover, if losses persist, the Fed could print more money.

Still, with headline and core inflation both at 2.8% in November, a sizable increase in central-bank money would make it more difficult for the Fed to bring inflation down to its 2% target. 

Thus, significant central-bank losses, without government compensation, could eventually cause even an operationally independent Fed deliberately to expand central-bank money on a scale that it knows to be incompatible with price stability. 

Avoiding a default on its debt and other contractual obligations would likely take precedence. 

This scenario would be especially unfortunate if fiscal unsustainability puts more pressure on the central bank to monetize sovereign debt.

Willem H. Buiter, a former chief economist at Citibank and former member of the Monetary Policy Committee of the Bank of England, is an independent economic adviser.

Anne C. Sibert is Professor Emerita of Economics at Birkbeck, University of London.