How the Federal Reserve Makes Money
Federal Reserve Makes Money
The Federal Reserve may seem mysterious to many Americans, especially with news stories of the bank raising (and then lowering) interest rates. But it’s an institution that is critical to how the U.S. economy works. As the central bank for the country, it does far more than manage short-term interest rates; it aims to stimulate economic growth, protect consumers, and ensure that transactions are secure and efficient.
Despite these lofty goals, the Fed is not a profit-maximizing institution. Instead, Congress established it as an independent government agency with public objectives of maximum employment and stable prices, and the Fed has tools to accomplish these objectives through monetary policy actions such as adjusting interest rates. These policies can lead to losses for the Fed. Does this impact its ability to make monetary policy?
To understand how the Federal Reserve makes money, it helps to break down what exactly is in its portfolio. The Fed’s assets primarily consist of U.S. Treasury securities, mortgage-backed securities, and other bonds that it bought in the open market. The money it earns from these investments is called “interest on reserves.”
How the Federal Reserve Makes Money
Interest on reserves is the interest banks and nonbank financial institutions earn on cash they keep overnight in accounts at their regional Federal Reserve Bank. This interest is a primary tool for moving the federal funds rate, because banks want to earn a return on their deposits and won’t lend at a rate below what they can earn in the market.
The Federal Reserve is also able to influence short-term interest rates through open market operations, which involve buying and selling Treasury securities in the marketplace. This can raise or lower the federal funds rate, which is used to control inflation and interest rates more generally. When the Fed buys and sells securities, it earns a profit on its purchases (or a loss if it overpays).
In addition to the income from its portfolio, the Fed receives income from its services. It loans money to other banks, acting as a middleman in their lending process, and it buys and sells mortgage-backed securities and other assets to stabilize the mortgage market. The Federal Reserve also has administrative expenses such as payroll and rent for its offices.
In the long run, the Fed does not face any risk of default because it has a large enough balance sheet to meet its liabilities. However, if the Federal Reserve booked significant losses for an extended period of time, those cumulative losses would eventually outstrip its profits and result in a deferred asset balance that needs to be paid down with future earnings. This process would slow down the Fed’s ability to implement monetary policy as intended. This is why the Fed carries out periodic audits to verify that it has properly maintained its accounting practices. The federal auditors report the results of these audits to the Fed’s board each year.