Your Money: The $85 billion question: How does Fed do it?

Where does the Federal Reserve get $85 billion a month to buy bonds? Does it borrow the money or just print more? How is the money transferred to bond sellers? Will the Fed or the taxpayer reap a profit or loss? When does the Fed plan to sell all these bonds it has bought as part of "quantitative easing"?

Ray Stone, founder of Stone McCarthy Research Associates in Princeton and a former Fed insider, explained: "The Fed pays for securities it buys simply by crediting the reserve balances of the sellers' banks. In other words, it is simply an accounting entry," he explains.

Let's say the Fed wants to buy $10 billion in bonds one day from, say, Morgan Stanley.

Instead of money changing hands, the Fed makes a bookkeeping entry to credit Morgan Stanley (almost like adding a credit to a checking account) by $10 billion.

Imagine the Fed does this over and over, buying from different "primary dealers," a title some Wall Street firms hold, or from mutual fund giants like Vanguard or PIMCO, until it's accumulated $85 billion in bonds for the month.

Yes, the Fed's only creating accounting entries, but the central bank is increasing total reserves - the amount of money in circulation. "Some people say this is tantamount to 'printing money,' although there is no actual printing of currency, but the Fed increases the volume of reserve balances by buying securities," Stone adds.

"The point is that the Fed isn't borrowing money to buy bonds, but is rather creating reserve balances. The securities show up as an asset on the Fed's balance sheet, and the creation of reserves is a liability."

Does the Fed make money on the bonds it has bought? So far, yes, the bonds have risen in price - but it's no guarantee that will remain the case. Whoever is the biggest buyer is also supporting the price.

Last year the Fed earned about $90 billion in profits, compared with about $30 billion in years prior to the bond purchases. Fed profits are given to the U.S. Treasury. So far, taxpayers have benefited, not only because of a reduced deficit, but because interest rates are lower, Stone estimates. He adds, "Net-net I would say taxpayers come out on the plus side of the equation."

But this may change, when it comes time for the Fed to tighten rates, which would entail paying higher interest on deposits. The Fed's profits would drop, as would repatriation of Fed profits to Treasury. Worst case, the Fed could suffer losses.

If the Fed decides to sell these bonds, instead of holding them to maturity, the Fed would likely lose money, as the prices would likely be lower than at the time they were purchased. 646-797-0759

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