How is the Federal Reserve's profit calculated?

Economics Economics Questions
1

I have read (e.g., http://en.wikipedia.org/wiki/Federal_Reserve_System) that the Federal Reserve pays a fixed portion of its profits to the holders of its “stock” and the rest of its profit is handed to the U.S. Treasury.

How is this profit calculated? How can the Fed even be said to have made a profit? After all, all money is Fed liabilities, which, if they return to the Fed are therefore canceled out and disappear into nothingness.

Suppose, for example, the Fed purchases an asset for $100. The Fed purchases it by issuing new liabilities. So its liabilities (thus the money supply) increase by $100 and its assets increase by $100. If it were to sell the asset for $100, then its liabilities would decrease by $100 and its assets would decrease by $100, and its balance sheet would be back where it was.

Now, if after purchasing it, the market price of the asset goes up to $150, then (all else being equal) the Fed’s assets have increased by $50 above its liabilities. This might be called “profit”. But then how is the ‘profit’ given to the ‘stock’ holders and the U.S. Treasury? If it sold the asset (for $150), all that would happen is that its liabilities and assets would both decrease by $150 (and thus its assets would still exceed its liabilities by $50).

The only thing I can think of is if the Fed simply creates new liabilities of $50 and hands them out as its “profits”, without receiving any asset in exchange? Is that what happens? At the end of the year if its liabilities are less than its assets, does it just issue new liabilities (increasing the money supply) up to its assets to make the two equal (or only part of the difference)? If so, then what about when the value of the assets fall, and its assets are less than the liabilities? How would it make up the difference then?

2

They also make a good amount of profit from the yield on the debt they bought from the treasury.

3

I think these might help:

"Can the Fed Become Insolvent? "

“Can a Central Bank Go Broke?”

(For more, you can always count on Mises Daily. And especially Bob Murphy. They’re not all here, but most are: Federal Reserve#Mises Dailies)

4

Yes.

No. In accounting terms, the asset is still recorded at historic cost of $100.00. There is no revaluation of the asset, i.e. writeup from $100.00 to $150.00, until the asset is sold.

For example, gold held by the Fed is still valued at $42.22 per ounce on its balance sheet, even though the present price is above $1600 per ounce.

Good question.

This depend on the Fed accounting, but in essence the asset could be revalued at $150.00 upon sale, and then the asset removed from the assets side at a value of $150.00. If this is the case, then yes, the assets side would decrease by $150.00.

No. If the Fed revalues the asset to $150.00, then the asset would be removed at $150.00. In other words, the assets side increases by $50.00, then decreases by $150.00.

No. The Fed sells the asset for $150.00 (exchanges the asset for Federal Reserve Notes valued at $150.00, and then cancels them).

For the balance sheet to balance, the Fed decreases its liabilities by $150.00 (cancels the Federal Reserve Notes), then increases its surplus account by $50.00, thereby recording a “profit” of $50.00 to the Fed.

The surplus account is equivalent to the “equity” account on a normal balance sheet, and is not a liability.

Note that the funds in the surplus account (with the $50.00 “profit”) does not exist as normal Federal Reserve Notes, but “money” it owes only to itself, and does not circulate. Thus, those funds in that surplus account might as well not exist at all.

Because Federal Reserve Notes in the amount of $150.00 has been removed from circulation, the net effect would be a monetary contraction of the base money supply.

5

Thank you. Let me illustrate what we’ve been saying to make it easier to follow.

Let’s suppose we start out with $1000 assets and liabilities:

ASSETS LIABILITIES

1000 1000

Then a new asset is purchased for $100:

ASSETS LIABILITIES

1000 1100
100 (new asset)

Later, the asset is sold for $150. After this, the sheet looks like:

ASSETS LIABILITIES

1000 950

Surplus account: 50

Where the “Surplus account” is defined as assets minus liabilities. Prior to the sale, the suruplus account was zero.

So, back to the original question, how is the “profit” distributed to, say, the Treasury? Like I said before, my only thought is that they would have to issue new liabilities, handing them to the Treasury, resulting in:

ASSETS LIABILITIES

1000 1000

This last step would be an increase in liabilities without gaining any asset in return. And would be an expansion of the money supply over the previous state. If this is how it works, does the Fed do this with the entire surplus account? Once per year?

And then my other question was what happens if the Fed purchased bad assets and after certain purchases and sales ended up with something like the following?

ASSETS LIABILITIES

500 1000

Surplus account: -500

So then obviously there would be no ‘profit’ to distribute. And I guess there would be nothing to distribute until they are able to bring the surplus account into the black sometime in the future? That is, from then on if they were to make a “profit” of $100 each year, it would take 5 years before the surplus account becomes non-negative, and then finally on the sixth year they’d have something do distribute?

6

Step 1. Credit the surplus account with the profit.

ASSETS LIABILITIES

1000 950

SURPLUS

+50

Step 2. Move the $50.00 from the surplus account to a Treasury liabilities account.

ASSETS LIABILITIES

1000 950 (Held by public)

50 (Treasury account)

SURPLUS

0

Result: Base money supply increases by $50.00 resulting in a monetary expansion.

No. Per the Federal Reserve Act, the surplus account must equal the capital account, i.e. the paid-in “equity” the private banks paid to the Fed in exchange for Federal Reserve stock at a district bank.

Excess funds in the surplus account must be distributed back to the Treasury.

Yes. If the surplus account is greater than the capital account, then the excess funds (in the surplus account) is distributed back to the Treasury.

See above.