The fallacy of Fed ‘profits’ (and ‘losses’)

February 20, 2013

Richard Fisher, the Dallas Fed’s colorfully hawkish president, enjoys touting the remittances that the central bank makes yearly to Treasury, earned, circularly enough, mostly on the returns of the Treasury bonds the Fed holds. Here’s Fisher in September 2010:

All the emergency liquidity facilities that the Federal Reserve instituted were closed down and did not cost the taxpayers of this great country a single dime. Indeed, last year, as we finished up this work, the Federal Reserve paid $47.4 billion in profits to the Treasury. Imagine that! A government agency that (a) created programs that actually worked as promised, (b) made money for the taxpayers in the process and (c) undid the programs – all in the space of about 28 months – once they had done their job.

The amount has only grown since then, as the Fed expanded its asset purchases in an effort to support a subpar economic recovery, totaling a record $88.9 billion for 2012.

But for Bob Eisenbeis, a former Atlanta Fed economist now at Cumberland Advisors, any discussion about Fed “profits” is inherently deceptive. He explains in a research note:

That Fed remittances are considered profits is a total misrepresentation and a fiction. The Fed is part of the government and is not a private-sector, profit-making entity. (The Federal Reserve Banks are quasi-public, but the Board of Governors is a government agency, and the system’s debts are guaranteed by the government.)

The Fed purchases Treasury debt from the public, paying for that debt with deposits it creates by a stroke of the pen. Looking at the Fed’s portfolio of securities from the perspective of the nation’s consolidated balance sheet, we see that one form of government debt (Treasury debt) is taken out of circulation and replaced with another form of government debt (Federal Reserve liabilities).

In effect, Treasury debt is taken out of circulation and is now owned by the government. It just happens to be the debt is on the books of the Fed and not the Treasury, but that is simply an accounting artifact and effectively the debt has been retired. The Treasury pays the Fed interest, which is an intra-governmental transfer of funds. From the funds received from Treasury, the Fed extracts both its operating expenses and contributions to capital, makes the required 6% dividend payment to member banks, and remits the remainder back to the Treasury.

Which brings us to the latest worry about the potential side effects of quantitative easing. Some economists fear that, as interest rates begin to move higher, the Fed will suffer a “loss” on its portfolio, meaning its operating expenses exceed the return on its holdings.

A Fed “loss” would not be particularly meaningful in an economic sense. Central bank officials would simply defer payments to Treasury into future years, as described in this recent Fed paper on the subject.

Still, some worry this could pose a serious political liability that might expose the central bank to unwelcome scrutiny from U.S. lawmakers, some of whom have been heated critics of bond buys.

“While this is of little macroeconomic significance, it will not go unnoticed,” Charles Plosser, president of the Philadelphia Fed and a noted policy hawk, said in November. “It is a risk to perceptions about the institution, which eventually may put the Fed’s independence at risk.”

Fed Vice Chair Janet Yellen, a potential successor to Chairman Ben Bernanke, who is widely expected to step down when his second term expires in January, was more sanguine. She told an AFL-CIO conference last week:

Yes it is possible in the course of trying to carry out monetary policy, that there will be a period of a year or even several years in which those remittances fall to zero. Now, that does have implications for the Treasury’s income. But if one wants to worry about that I would suggest a larger frame of analysis for thinking about it. And that would be, what would be the effect of the Federal Reserve’s policy on the overall debt level of the U.S. economy? Not to look at it in the narrow terms of – ‘could there be a period in which the checks we’re sending to Treasury falls to low levels?’ – but what’s the impact of our overall policy on the debt level of the countries?

If you think about that and actually start to do some back-of-envelope calculations, you’ll see that if our policy has even the tiniest favorable effect on our economy in terms of the path of employment and GDP growth and we are successful in pushing down longer-term interest rates – those are the major impacts, and all positive, on the deficit and debt level of the country. So, I would say looked at in the right way, this is a policy that is not only good for output and employment and American workers, but also for the federal finances overall.

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Former Atlanta Fed economist Bob Eisenbeis is dead on when he says it is a misrepresentation and a fiction to describe Fed remittances to the Treasury as profits.

Eisenbeis states: “In effect, Treasury debt is taken out of circulation and is now owned by the government. It just happens to be the debt is on the books of the Fed and not the Treasury, but that is simply an accounting artifact and effectively the debt has been retired.”

The operative word here is “retired” because it directly relates to the hysteria over the debt ceiling.

Eisenbeis continues: “The Treasury pays the Fed interest, which is an intra-governmental transfer of funds. From the funds received from Treasury, the Fed extracts both its operating expenses and contributions to capital, makes the required 6% dividend payment to member banks, and remits the remainder back to the Treasury.”

In other words, the $1.72 trillion of Treasury debt held by the Fed is in effect debt that the government owes itself. Our children and grandchildren are not even involved. As Eisenbeis points out, for all practical purposes this Treasury debt has been “retired”. Why then should it apply to the $16.4 trillion debt ceiling which has already been breached with outstanding debt now weighing in at $16.54 trillion?

If as Eisenbeis argues the $1.72 trillion in Treasury holdings of the Fed have in effect been “retired”, why can’t the Fed and Treasury simply wave a magic wand over it and declare that it no longer applies to the debt ceiling? That measure would reduce outstanding debt down to about $14.8 trillion, which would buy policy makers another year or so of time to come up with sensible pro-growth economic policy rather than lurch from one fiscal crisis to the next amid plans for austerity that risks sending the economy back into recession.

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