The Federal Reserve delivers its profits, after expenses, to the US Department of the Treasury. The Federal Reserve also holds several trillion dollars' worth of government debt. So when the securities that they hold reach maturity and the government pays the maturity value on them, does the Federal Reserve just pay it right back to the Treasury Department, effectively canceling the debt?
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2$\begingroup$ The repayment of principal is not profit except to the extent that they were not purchased at par. The Federal Reserve System created liabilities when it originally acquired the Treasury bonds (typically by increasing commercial bank deposits/reserves at the Fed) and can use the repayment of the bonds either to extinguish some of those liabilities or to acquire new assets. $\endgroup$– HenryCommented Mar 8, 2023 at 8:50
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$\begingroup$ Thanks, I think I understand everything in your comment except for the part about extinguishing the Fed's liabilities. Where does the money go in that case? The Fed owes that money to itself, correct? $\endgroup$– studentCommented Mar 8, 2023 at 13:58
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$\begingroup$ The Treasury pays off its bonds by "sending money" to the bondholders, in effect instructing a credit to the bondholders' accounts and a debit the Treasury's accounts. So this would either increase the Fed's assets or, if the Fed has an existing liability that this offsets, reducing the Fed's liabilities $\endgroup$– HenryCommented Mar 8, 2023 at 14:55
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$\begingroup$ Yes I know the Treasury pays the money to the Fed. But when the Fed purchased the bonds from the banks, it paid for them with money which it created, right? So are you saying that the money which the Fed receives from the Treasury Dept at the bonds' maturity date is used to pay back the money that the Fed owes itself for the bond purchase? $\endgroup$– studentCommented Mar 8, 2023 at 20:32
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The repayment itself is not part of the profit. That is just treasury returning back to Fed the money they borrowed. For example, when that treasury was originally issued and sold at \$1000 (assume face value is also \$1000 the government received \$1000 dollars from Fed, and when the government repays the money to the Fed, that is what effectively 'cancels' the original loan. If Fed would forward that money to treasury that would effectively be equivalent of Fed just giving \$1000 forever.
However, the interest that government paid on those treasuries will be part of Fed's profit. So any interest government pays will go back to the treasury, meaning that effectively the government pays the interest rate to itself.
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$\begingroup$ Does the Fed ever purchase directly from the Dept of Treasury? I thought they always bought securities from commercial banks when conducting OMO. $\endgroup$– studentCommented Mar 8, 2023 at 14:03
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$\begingroup$ @student it does not, it does it on secondary market, but that is the same thing with just one extra step. The reason why they do it on secondary market is that in US when institutions like fed were created people were very scared of big government so almost all US institutions have extra walls erected between executive branch of the government and themselves. However, from an economic perspective there is no significant economic difference between fed directly buying it from the treasury or buying it on secondary market, the money just pass via intermediary before reaching gov. $\endgroup$– 1muflon1 ♦Commented Mar 8, 2023 at 15:23
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$\begingroup$ Well my understanding was that they buy/sell on the open market in order to affect the money supply and interest rates. $\endgroup$– studentCommented Mar 8, 2023 at 20:17
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$\begingroup$ @student even if they did it directly on primary market it would have effect on money supply (through government) and on interest rate since interest rates on primary and secondary market closely follow each other. $\endgroup$– 1muflon1 ♦Commented Mar 8, 2023 at 20:52