The reality has been happier. The Fed’s assets have ballooned to nearly $3 trillion, mostly in Treasuries and mortgage-backed securities (MBS). It paid $89 billion in profit to the Treasury for 2012, the largest in a string of record-breaking remittances (see chart). Before the crisis, the Fed’s profits were typically only a third of that.
The Fed makes its money much as most banks do: from the spread between the return on its assets and the interest paid on its liabilities. The Fed’s liabilities are principally made up of currency in circulation, which pays no interest, and reserves, the cash that commercial banks keep on deposit at the Fed. Since 2008 these reserves have exploded to $1.6 trillion, on which the central bank pays only 0.25% interest. The difference between that modest cost and the average return of about 3.5% on its bond holdings explains the whopping “seigniorage”, as the profit the Fed earns from printing money is called.
Some Fed officials worry about what comes next. When the Fed raised rates in the past, it meant little for profits because reserves were trivial and earned no interest. Since 2008 the Fed has paid interest on reserves in order to maintain control of interest rates. So when the Fed eventually tightens monetary policy, it will have to pay out more interest. To absorb reserves it may have to sell some bonds for less than what it paid, incurring capital losses. In theory, it could end up losing money, a risk that grows the more bonds it buys.
In a recent paper five Fed economists calculated that if the Fed buys $1 trillion of bonds this year and starts tightening in 2014, then the Fed’s profit will turn to loss by 2017. Cumulative losses could eventually reach $40 billion, from higher interest expenses and realised losses on MBS sales (the economists assume the Fed will hold its Treasuries to maturity). If interest rates rise more sharply than expected, losses could peak at $125 billion, and the Fed would pay no profit for six years.
