Last week, The Federal Reserve announced a record $46 billion profit for 2009 - the highest earnings in the central bank's 96-year history. Because the central bank has the ability to control the money supply, it effectively funds itself. However, as a government agency it is not-for-profit, so any excess gets returned to the Treasury.
Robin Lumsdaine, the Crown Prince of Bahrain Professor of International Finance, offers her insight on the news. Lumsdaine served as Associate Director at the Board of Governors of the Federal Reserve System before moving to Kogod in the fall of 2008.
Before this year, the largest refund to the Treasury was $34.6B -- which was eclipsed by $10B. How did a profit of this magnitude come about?
While there may have been other factors, three things immediately come to mind. First, the magnitude of Fed purchases was much larger than in previous years, so that even if the return on assets was constant, the dollar amount would have been greater. Second, the composition of the purchases differed; that is, because of the crisis, the Fed needed to purchase riskier assets than they usually do, and riskier assets tend to generate higher returns. Finally, many of the purchases were made at a time when prices were extremely depressed; as prices returned to more appropriate levels, the result was gains on those exposures.
Much of the earnings are due to the Fed's purchase of bonds; why was this an unusual, and perhaps risky, choice?
I believe the bond purchases were aimed at stabilizing rates and to flatten the yield curve – a characterization of the relation between interest rates and the time to maturity of bonds – which had become very steep. The steep yield curve (very low short-maturity rates combined with relatively much higher long-maturity rates) was exacerbating the situation, as it inhibited longer-term credit and funding arrangements.
Buying bonds to influence the yield curve wasn’t so much a risky choice as it was a challenge for the Fed, because their main policy instrument is the Federal Funds Rate – which is very short-term. Their ability to influence longer-term rates has historically been less targeted, instead relying on more indirect channels.
The Fed has not traditionally focused on maximizing profits; however, the actions taken since the crisis are more similar to those of a private bank. Do you expect a shift back to the Fed's 'old' operational style once the economy rebounds completely, or do you think the Fed's role has shifted permanently?
It's not surprising that during the crisis, some of the Fed’s actions might be compared to those of a private bank. The central bank is, after all, "the lender of last resort." For a brief period there, it really was the only bank lending.
In my opinion, the Fed was forced into its role by the severity of the crisis. Maximizing profits has never been one of its objectives, nor is it today. However, the Fed is very aware that the actions taken during the crisis – while necessary – placed a huge burden on its balance sheet, the United States' balance sheet, and ultimately on the taxpayer. So I think it's fair to say they're doing everything they can to ease that burden and try to minimize it.
On the basis of its actions alone, I wouldn't say the Fed's role has shifted permanently. The Fed has been very consistent in emphasizing that the steps it took were due to "unusual and exigent circumstances" and that it had no intention of permanently extending its authority. That's not to say that nothing will change. The Fed has also been upfront in identifying areas for improvement or added focus. And I believe they accept that having a significant role in systemic risk management is consistent with the Fed’s existing mandate.
I do worry, however, about proposals that would significantly alter the Fed’s role or responsibilities. I am not sure that people understand how important the Fed's credibility was during the crisis. It may not always be possible to avoid a crisis, but in the event one occurs, it is absolutely vital to have tools in place to deal with it, and that inevitably includes having a strong central bank.