By Christian Drake
With the Fed balance sheet expansion bonanza continuing unabated, it feels like the right time to re-highlight the (incestuous) Federal Reserve-Treasury relationship in the context of quantitative easing. It is a trivial data highlight, but one that is disturbing, perversely amusing, and well-worth revisiting every once in a while: Fed Remittances to the Treasury.
To ensure we are not misrepresenting the circularity of the relationship, below is the Fed’s own description of what it does with the money (i.e. the interest earned on the treasury & MBS debt it holds) it is paid by the Treasury Department.
(Spoiler: it just gives it back)
Associated with the substantial change in the Federal Reserve’s balance sheet has been a notable change in the Federal Reserve’s net earnings. The Federal Reserve generates a substantial portion of its income from the interest‐earning assets held by the Federal Reserve Banks, particularly in the SOMA portfolio.
Federal Reserve expenses include operating expenses necessary to carry out its responsibilities, as well as interest expense related to certain liabilities of the Federal Reserve Banks; currently, the largest interest expense stems from reserve balances. Federal Reserve income, less expenses, plus profit and loss on sales of securities, is referred to as “net income.”
The FOMC pursues its statutorily mandated goals of full employment and stable prices, and the resulting net income is simply a by‐product of the actions taken. The Federal Reserve is statutorily required to pay dividends on capital paid in. Under Board of Governors policy, after retaining sufficient earnings to equate surplus capital to capital paid‐in, the Federal Reserve Banks remit residual net income to the U.S. Treasury. (emphasis ours) - Fed Paper
In essence, the Fed keeps enough “income” to pay interest on reserves and fund its own operations, then gives anything left over back to the Treasury.
So, in the context of QE: the Fed prints money and buys Treasuries >>> the Treasury pays the Fed interest on its holdings >>> the Fed gives the money ($90 billion in 2012) back to the Treasury.
The net result of this is that the U.S. benefits in two primary ways. First, with the Fed in the market, Treasury yields stay lower than they would otherwise and sovereign cost of capital remains artificially depressed. Second, because the Fed simply gives interest earnings back to the Treasury, debt is artificially lower than it would be otherwise as well.
The best part is that this has scale. So long as rates remain low and interest income rises faster than interest expense, the larger the Fed balance sheet grows and the larger percent of total debt outstanding the Fed holds, the larger the benefit to the treasury on the back end. Further, if the Fed balance sheet grows at a premium to deficit spending, we can continue to issue more net debt at a lower incremental cost.
Everyone wins. Right?
Christian Drake is a Senior Analyst at Hedgeye Risk Management.