The Fed’s 100th year birthday

Guardian Angel

By construction a central bank’s success is generally assured. In particular, in even though the US Congress legislates aspects of the Fed’s operations, the Fed is profitable enough to both cover its administrative costs, as well as generate substantial profits, almost all of which is remitted to the US Treasury. This is ostensibly subject to GAO oversight.

This profitability arises by virtue of the Fed having a monopoly position as issuer of currency. Do note that “profit” is quite different than printing money. Though many suggest that the Fed can print money (and it can), printing money merely creates Fed Balance sheet: an asset and a liability of exactly equal size. The profit comes from the difference in earning rates on assets and liabilities, less operating costs. Virtually all of the Fed’s capital therefore comes from the fraction of profits it has retained starting in 1914. This currently amounts to cumulatively $55 billion, no more, no less[8].

While demand for money, US Dollars, may seem instinctual, scholars suggest demand for officially issued money is conceptually cemented by the IRS’s authority to collect taxes. It is this demand for money that creates a positive spread between the special liabilities the Fed issues, and the generic assets the Fed owns, hence its profit.

To the extent that the Fed’s zero interest (currency in circulation) or low interest (reserves) liability is backed by higher yielding, default-free, interest-bearing assets, a profit is assured. These assets typically consist of US Treasury debt, agency securities, bankers’ acceptances, and a small amount of gold and foreign securities.

So the Fed operates a natural and legislated monopoly, and not surprisingly has been profitable every year since 1913. The profitability of the Fed, or the spread between assets and liabilities, is further assured by the perceived unlimited liquidity of the Fed. This gives it the ability to extend the duration of its assets, knowing that it can buy time during short-term panics, and somewhat appropriately use cost-based (rather than mark to market) accounting. When others are forced to sell assets, at distressed prices, the Fed can issue liabilities, and buy assets, to temporarily stem the distress. Ultimately this allows the Fed to run a modest maturity mismatch. Historically, even during times of distress, these assets have been short term in nature consisting of mostly money market instruments and Treasuries with maturities of less than 5 years. Recently, of course, this has changed dramatically.

In times of budget scrutiny (as if that is not always the case in a democracy) these profits serve as the central bank’s guardian angel, somewhat shielding it from needing to bargain for annually legislated budget authority, and currying it favor, with various constituencies.

Click here for footnotes.

comments powered by Disqus