The Fed’s big dollar gamble

Rogaine, as you may know, was originally developed as a blood pressure medication but was “repurposed” because it had the side effect of promoting hair growth. The two Fed side effects we’ll discuss today — prospective currency wars with some major trading partners, and a reduction in the federal budget deficit — are far less known than Rogaine’s. But, with all due respect to follicularly challenged males, they’re a lot more important.

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The first Fed side effect, currency wars, is an example of how something good — stimulating our economy by lowering interest rates — can have a downside. Cutting interest rates faster and more deeply than most other central banks has weakened the dollar against the currencies of many of our major trading partners. The Fed doesn’t exactly run around telling the public that it’s happy to see this happen. But that’s the case, because a gradually declining dollar encourages job growth in our country by making our exports cheaper and our imports more expensive.

The problem, which reared its head in the run-up to the Great Depression 80 years ago, is that if everyone devalues, no one benefits. Instead, you get widespread instability, fear, and trade wars. The prospect of that makes even a congenital optimist like me more than a little nervous.

You can see from the chart below that the dollar has dropped more than 10% against the currencies of our major trading partners since 2009, when the world financial crisis was in full swing and the Fed invented one program after another to drive down interest rates. The dollar may well have been artificially high in 2009, but nevertheless, its subsequent decline has had a major impact on trade.

U.S. manufacturing is showing signs of recovery, in part because the dollar’s decline has made domestically produced products more competitive with foreign products. But what’s good for us is bad for countries whose products are being priced out of our market and are being forced to compete with cheaper (in terms of their currencies) U.S. goods in other markets, including their own.

The new Japanese Prime Minister, Shinzo Abe, is pushing his country’s central bank to run down the value of the yen as part of his economic stimulus program. China is thinking along similar lines. Germany, which doesn’t control the euro directly — the European Central Bank does — is pushing programs that are nominally aimed at economically struggling euro countries, but that will also drive down the euro’s value, making Germany more competitive.

The Fed is playing a complicated, high-stakes game here. The dollar is the world’s reserve currency, which allows us to suck in money from all over the world to fund our trade and budget deficits without having to balance our accounts. There’s a tension between our internal situation (a lower dollar is good) and our role as a reserve currency (a dollar that falls too rapidly risks spooking investors and costing us our reserve-currency status).

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By contrast, the second side effect of the Fed’s low-rate policies — helping finance our federal budget deficit — is an unalloyed good thing.

The Fed has been making huge profits since its stimulus programs kicked into high gear four years ago, and it has contributed virtually all of them to the Treasury. Last year, the Fed says, it made about $91 billion in profits and sent $88.9 billion of that to the Treasury. That’s up from $31.7 billion it sent in 2008, the last almost-normal year, and $47.4 billion, $79.3 billion, and $75.4 billion from 2009 through 2011, respectively.

The Fed’s profit is soaring because the size of its securities portfolio has risen, to about $2.65 trillion at the end of last year from about $750 billion at year-end 2007. The Fed has been buying Treasury and mortgage-backed securities by the boatload in order to raise their prices, which has the effect of driving down interest rates.

The Fed bought these securities with money that it essentially created out of thin air and then credited to the Fed accounts of the financial institutions that sold the securities. The Fed pays nominal interest on the money that sellers leave in those accounts, and no interest on the money withdrawn from them for other purposes, such as making loans. Meanwhile, the Fed collects interest on the securities it has bought. Thus, expanding the portfolio has been hugely profitable.

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“The Fed isn’t running these programs to maximize its own profit; that’s just a side effect,” says Ray Stone of Stone McCarthy Research Associates of Princeton, N.J., a leading Fed maven. He predicts that the Fed will post higher profits — and send more money to the Treasury — this year than it did last year.

On top of that, the Fed’s projected purchases of about $540 billion of Treasury securities this year will indirectly fund about half of this year’s federal budget deficit. Nice work if you can get it. And keep it.

There’s one crucial difference between Rogaine and Fed rate-cutting: staying power. You can take Rogaine indefinitely, but the Fed’s keep-lowering-rates program doesn’t have an indefinite shelf life. Bernanke has driven U.S. interest rates to their lowest level in modern times, but he can’t drive them below zero. Even if the Fed is reluctant to tighten, it doesn’t control the world — and it can’t indefinitely withstand pressure from financial markets and from other central banks. When the Fed’s inevitable dial-back kicks in, the dollar will rise, and Fed profits and remittances to the Treasury will fall. The bottom line: Pharmaceutical stimulus is forever. But Fed stimulus isn’t.

–Reporter associate: Doris Burke

This story is from the February 4, 2013 issue of Fortune.