EVER since the Federal Reserve first started buying up financial assets back in 2008, some have fretted about taxpayer exposure. The private debt purchased by the Fed to prop up the financial system might sour. The government bonds it has bought with newly created money, a strategy dubbed “quantitative easing” (QE), could fall in value if interest rates rose.
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.
For the government as a whole, these losses are less than meets the eye. The interest paid on reserves by the Fed partly substitutes for interest the Treasury would be paying the public if its bonds were not held by the central bank. But it may still worry some Fed officials, given the attacks it regularly endures from Republicans in Congress. “Being seen to have lost taxpayer money could only intensify pressures on the Fed, to the point where at least some of the central bank’s independence could be put at risk,” says Roberto Perli, a former Fed economist now with ISI Group, a broker. He thinks some officials could be worried enough to oppose continuing QE once it reaches $1 trillion at the end of this year, even if the economy is not yet up to snuff.
Whether such concerns would really blow the Fed off the course dictated by economic circumstances is debatable, however. The Fed would not actually need a taxpayer infusion. One of the perks of central banking is that it can print the money needed to pay interest. If that generates a loss, it creates an offsetting “deferred asset” on its balance-sheet, representing future profits it won’t have to send to the Treasury. The forgone profit would pale in comparison with total interest saved, higher tax revenue due to stronger growth and roughly $500 billion of profit that QE had previously made possible. More importantly, the losses would occur only once the economy was healthy enough to require higher interest rates, which, after all, would be proof that QE had worked.