Forgive me for posting this link again but understanding the Fed's balance sheet means understanding QE and its long term viability. http://www.federalreserve.gov/releases/h41/
Lets focus on the principal items:
Assets
The Fed owns a bond portfolio of $4.196 trillion from which earns interest.
If we assume a return of 3% (MBS will be higher, and some T-Bonds will be lower), that will earn the Fed $125.9 billion per year.
Liabilities
Most of the funding for the Feds assets comes from two sources:
1. $1.295 trillion from "Currency in Circulation". This is money earned from the sale of notes and coin to the US commercial banks. This is free money for the Fed. No interest is paid.
2. $2.793 trillion from "Reserve Balances with Federal Reserve Banks". This is money belonging to the US Commercial banks on deposit with the Fed.
Note on the cost of Reserve Deposits to the Fed: The conditions on which Reserve Deposits with the Fed are held is one of the mysteries shrouded in Central Bank-Commercial Bank confidentiality. There are one of two possible arrangements: 1. The banks negotiated the placement of the funds with the Fed and are receiving the Fed Funds Rate in return. If this is true, the Fed is paying the banks $6.983 billion per year in interest. 2. (But more likely) the money is uninvested funds sitting in commercial bank clearing accounts with the Fed, in which case the Fed is paying not interest at all for the use of the money. Uninvested funds are accumulated when the government spends money (putting money to the banking system) but the Fed takes no open market action to soak up this new surplus liquidity.
In summary:
The Fed is earning large amounts of money in interest from the bonds it owns and is paying next to nothing to fund them. Last year they made a profit of $90 billion, and this year I expect that they will make over $110 billion.
So what could change that might end this "ideal" arrangement?
Are the Fed likely to loose the liabilities that are funding the bonds?
1. The only way they can loose the $1.295 trillion Currency in Circulation is if the people who are holding those currency notes start depositing them in bank accounts, in which case the commercial banks will start selling the notes back to the Fed. This is very unlikely, as most of this money is probably "black" and the owners don't want the IRS or law enforcement agencies on there backs.
2. The only way that the Fed will loose the $2.793 trillion in Reserve Deposits is if the Fed itself sells its bond portfolio, or in dribs and drabs as the bonds eventually mature. The Fed has no reason to sell its bond portfolio, as the US economy is still depressed. But if the US economy recovered sufficiently that Demand driven price increases started to emerge, then I would expect the Fed to start selling.
So the end game you are looking for is a genuine recovery in the US economy that is sufficiently advanced that capacity constraints might fuel Demand driven inflation. I think that threat is very distant while the US Congress persists with its current fiscal policies.
