Should We Celebrate the Fed's Record $82 Billion Profit?

This week the Federal Reserve announced that it made a profit of $82 billion in 2010. That's a new record, breaking last year's previous record high of $53 billion. On pretty much any level, $82 billion is a lot of money. Where did it come from, and who should celebrate these profits?

This actually relates to question e-mailed by reader Aquarius yesterday, who wrote:

If I were a financial reporter, I would want my readers to know who owns the Federal Reserve, and to whom goes the vast interest payments that we taxpayers pay each year.

First, the interest payments to which this reader presumably refers are those on the government securities the Fed buys. The Federal Reserve is an independent central bank, but it cannot retain its profit under the conditions by which it was established. So whenever its revenue exceeds its operating expenses, the surplus is remitted to the U.S. Treasury. In 2010, that amounted to $79 billion.

In this case, the Fed's profit came from a number of its portfolio holdings. Here's a breakdown of the revenue from its interest payments:

fed interest 2010.png

Some of it included interest on Treasuries. But the bank indicates that a large portion of this year's profit, $48 billion, came from interest on the debt or mortgage-backed securities of government-sponsored enterprises. It purchased more than $1 trillion of this debt since the financial crisis began.

So part of the interest paid by taxpayers on Treasuries the Fed owns goes to cover the central bank's operating expenses, in theory. But because its profits were so high, even if it didn't own a single Treasury, it would have still had a profit of about $53 billion. As a result, you could assert that taxpayers got back every penny that they paid the Treasury in interest, plus another $53 billion.

The effect of this is essentially monetizing debt. Think about the process that occurred. The Treasury issued some amount of debt that was purchased by the Fed. It then created money out of thin air to purchase that debt. The Treasury paid the Fed interest of $26 billion. The Treasury then gave the Fed back the principal amount associated with this debt upon its maturity. The Fed, if it didn't wish to buy anything else with that principal, destroyed that money it created or kept it as cash, but it gave the interest -- its profit -- back to the Treasury. These interest payments are effectively monetized debt.

In fact, the amount of debt monetization is actually probably even greater. To figure out how much money the U.S. government got for free, you would have to imagine a scenario where it didn't sell any money to the Fed. In that scenario, there would be less demand for Treasuries, so its interest payments would have likely been higher.

Let's imagine two fictional, but explanatory, situations:

Scenario I

Fed buys $500 billion Treasuries, where the weighted-average market yield is 1% for the year. The Treasury additionally issues another $1.5 trillion in debt over the same period at the same yield to other investors.

  • The Fed gets $5 billion in interest. (entirely remitted to the Treasury)
  • Other investors get $15 billion in interest.

Scenario II

The Fed does not participate in Treasury purchases. Without its demand, the weighted-average market yield is 1.5% for the year. The Treasury still issues $2 trillion in debt.

  • Investors get $30 billion in interest.

These yields and principal amounts are made up, but you can see what happens. In Scenario II, the borrowing activity of the U.S. costs $30 billion, but in Scenario I, it costs just $10 billion. Some portion of that difference, the $5 billion the Fed provides the Treasury in interest, results in additional money in the economy, and should eventually inflate the currency.

That's effectively a total of $10 billion in debt monetized in Scenario I. The Treasury got its Fed interest back and used it to pay that amount of the investor interest. But the other $10 billion saved results from the Fed's manipulation of market demand for government securities and does not result from additional money created in the economy.

Of course, if central bank intervention in government security purchases becomes too aggressive, then the market reacts negatively, and yields climb. In that case, investors sense increased inflation risk and higher default risk. The U.S. isn't at that point yet. So for now, the Fed's Treasury purchasing benefits the U.S. government. But only a fraction of its big profit for 2010 comes from this source. The other $53 billion came from gains on its other assets.