Where the Fed's Profits Come From Stimulus policies such as Quantitative Easing have had the side effect of boosting the Fed's net income, but they have also created a couple of big risks. Financial documents released by the Federal Reserve last week showed that 2011 was the second-most-profitable year for the U.S. central banking system. Net income totaled $77.4 billion, down only slightly from $81.7 billion in 2010. That's more than twice what the Fed was earning before the 2008-09 financial crisis. It's also more than double the amount earned by Exxon, Microsoft or Apple. Where does all this money really come from, who ends up paying for it, and where does it go? Conspiracy theorists claim that some global elite manipulates central banks and somehow siphons off their profits. In fact, central banks automatically earn income from performing their basic functions, and most of the Fed's profits go to the Treasury as a contribution to government revenue. Unless the Fed causes higher inflation, the only way the public pays is by missing out on potential interest. Every paper dollar in your pocket is a dollar on which you are not earning any investment income. MORE: U.S. Federal Reserve Earned $77 Billion in Profit in 2011 Whoever issues money generally earns a profit on the activity - a profit known as seignorage. When money is based on gold or other precious metals, the issuer of coins charges a mintage fee. Unscrupulous issuers can earn more by debasing the currency. The Roman Emperor Nero reduced both the weight and the purity of the silver denarius and used the silver saved to help pay for wars and for rebuilding Rome after the famous fire. Issuers of paper money - or more recently, electronic money - get the benefit of the money they create. Although governments or their agencies are normally the issuers, its easier to see how the process works if you look at travelers checks. When someone buys a travelers check from American Express, the company has use of the money until the check is cashed. Since some amount of travelers checks is always uncashed, AmEx has a chunk of money it can invest. Interest on that money is the seignorage that the company earns for offering the convenience of travelers checks. Similarly, people who use paper money are giving up interest they could have earned ­- and ultimately, that interest goes to the Fed. So why have the Fed's profits risen so much in the past two years? Two reasons: The Fed has created more money than usual and also has invested it in higher-paying assets. Here's why that has happened. Besides providing money we use in the form of cash, the Fed adds money to the banking system to adjust the level of interest rates. To stimulate the economy by lowering interest rates, the Fed creates money and uses it to purchase Treasury securities and other government debt, thereby releasing additional money into the banking system. Since the Great Recession began, the Fed's stimulus policies have tripled the size of its balance sheet. It might seem that lower short-term rates would limit the amount of interest the Fed could earn on all the extra money it created. But once short-term interest rates were very low, the Fed injected additional money into the banking system by buying Treasury bonds and other long-term debt, a strategy known as Quantitative Easing. Those securities pay much higher yields than short-term debt. The combination of more money and higher-yielding investments accounted for most of the record profits in 2010 and 2011. The Fed also earns a bit from interest on emergency loans and fees for banking activities such as clearing checks. About 90% of that total income went to the Treasury. Most of the rest went for the Fed's operating expenses, and a smidgeon was used to pay interest to large commercial banks that are required to invest a little of their capital in the Federal Reserve System. The Fed's recent profits may be huge, but they don't represent any kind of brilliant management. Rather, they are simply the byproduct of central banking policies that the Fed is pursuing for other reasons - chiefly efforts to keep interest rates low. Those stimulus policies have encouraged economic growth, but they have also created two big risks. The first danger is that the Fed has greatly increased its vulnerability to capital losses. Short-term Treasury debt is close to risk-free, but long-term debt can decline in value when interest rates rise (bond prices automatically fall when interest rates go up). If the economic recovery continues, it may become necessary to allow long-term interest rates to rise, which could cause big losses on the Fed's holdings of long-term debt. Indeed, the Fed has created a conflict of interest for itself that normally doesn't exist. The other problem is that the Fed's massive money creation over the past two years could eventually fuel a sustained upsurge of inflation if economic activity continues to pick up. Both those potential risks could become real dangers within the next couple of years, but fortunately they haven't materialized yet.