Greg Ip

Articles by The Economist’s U.S. Economics Editor

The Federal Reserve: The hedge fund of Foggy Bottom

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The original article is linked here.

If you do not adjust for risk, the Fed is making good money for Uncle Sam

 
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THE Federal Reserve does not set out to make bumper profits. But its 2008 annual accounts, released on April 23rd, would turn many a hedge-fund manager green with envy.

Like Wall Street’s finest, the Fed makes money on a spread. Its main source of funds comes from issuing cash, since currency in circulation is, in effect, an interest-free loan by the public to the central bank. The interest it earns on its loans and securities is almost pure profit, or “seigniorage,” most of which it remits to the Treasury.

Last year the central bank reported a whopping $43 billion in operating income. That was more or less the same level as in 2007, but meanwhile short-term interest rates had plummeted, ending the year near zero. That should have clobbered Fed income, as rate cuts did in the early days of the last recovery in 2002-04 (see chart).

But it did not, for two reasons. First, to shore up financial markets the Fed has pumped up its balance-sheet—its total assets were $2.2 trillion on December 31st, more than double their level of a year earlier. Second, it has been trading in low-risk, low-return Treasury debt and buying higher-yielding private debt—discount loans to banks, commercial paper, and mortgage-backed securities, for example.

The Fed has, in effect, been adding both risk and return to its portfolio. So far so good, despite mark-to-market losses on the securities it acquired bailing out Bear Stearns and American International Group. But as hedge-fund managers have learnt of late, you “reach for yield” at your peril. The risk is an occasional hit big enough to wipe out years of profits.

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Written by gregip

April 30, 2009 at 3:58 pm

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