Beginning with the Great Recession of 2007-2009, the Federal Reserve initiated a policy of “quantitative easing”, in which the Fed held substantial amounts of financial assets like US Treasury bonds and mortgage debt backed by the federal government. The problem at the time was that the Fed had cut its key interest rate to near zero. The idea was that if the Fed held such assets, interest rates might be somewhat lower, compared to a situation where these assets were sold in financial markets.
An obvious question raised at the time was whether the Fed was in fact just printing money to cover government borrowing. “Monetizing” debt in this way is generally considered a bad idea, as it leads to inflationary pressures and even doubts about the true value of debt in financial markets. But Fed economists at the time made a clear distinction between quantitative easing and debt monetization. Here is David Andolfatto and Li Li of the St. Louis Fed on the subject (“Is the Fed monetizing public debt?: February 1, 2013).
What is generally meant by “monetizing debt” is the use of monetary creation as permanent source of funding for public expenditure. Thus, to know whether the Fed has actually monetized its $1.2 trillion purchases of government bonds since 2008, one must know what the Fed intends to do with its portfolio of assets over time.
If the recent rapid accumulation of Treasury debt on the Fed’s balance sheet constitutes a permanent acquisition, then the corresponding supply of new money should remain in the economy (in the form of cash in circulation or bank reserves) also permanent. Because interest earned on securities held by the Fed is returned to the Treasury, the government can essentially borrow and spend that money for free. If, on the other hand, the recent increase in Fed Treasury debt holdings is only temporary (an unusually large acquisition in response to an unusually large recession), then the public should expect that the monetary base returns at some point to a more normal level. level (by selling securities or by allowing securities to mature without replacing them). In this last scenario, the Fed does not monetize the public debt, it simply manages the supply of the monetary base in accordance with the objectives set by its dual mandate. Means other than monetary creation will be needed to finance the Treasury debt returned to the public through sales on the open market.
Here’s a number from the Fed showing how its assets have changed over time. You can see the asset accumulation after the Great Recession – those early waves of quantitative easing. You can then see a slight decline in Fed asset holdings, as Aldolfatto and Li described above. The idea at that time was that the Fed would simply hold onto the debt it had purchased until that debt expired, and thus gradually and slowly let its holdings of assets gradually decline. A commonly used phrase was that the process would be about as exciting as watching the paint dry.
But then the pandemic recession hits, the US government runs extraordinarily large deficits to fund its pandemic relief programs, and given the uncertainties in global financial markets, Fed holdings take another dramatic jump. For reference, the numbers are in millions of dollars, so the “8M” on the right axis refers to eight million million, or $8 trillion.
So even if the Fed wasn’t monetizing federal debt around 2013, is it now? What is the current plan to gradually reduce the Fed’s now much larger holdings of government debt? Huberto M. Ennis and Tre’ McMillan of the Federal Reserve Bank of Richmond outline part of the plan in “Normalization of the Fed’s balance sheet and minimum level of sufficient reserves” (Economic note n°23-07, February 2023).
Ennis and McMillan write:
From the onset of the pandemic through the spring of 2022, the Fed’s balance sheet has grown significantly due to the Fed’s efforts to help market functioning and support the flow of credit to households and businesses. Banking system reserves are at record highs, well above the Fed’s desired long-term levels. With improving financial and economic conditions, the Fed began the process of balance sheet normalization in March 2022, through which it intends to significantly reduce the amount of treasury bills and mortgage-backed securities (MBS). ) that it holds in its System Open Market Account (SOMA) portfolio.
So what will happen, how far and how fast? Here, the desired reduction in Fed assets over time—essentially, the Fed holding fewer Treasury bonds and federally guaranteed mortgage-backed securities—intersects with the imperatives of the conduct of monetary policy at the daily. The main tool used by the Fed to conduct its monetary policy is to change the interest rate it pays on the reserves that the banks hold with the Fed, and thus to affect its key interest rate, called the rate federal funds. A The Fed website explains: ,
The FOMC [Federal Open Market Committee] has the ability to influence the federal funds rate – and therefore the cost of short-term interbank credit – by changing the interest rate the Fed pays on reserve balances that banks hold with the Fed. A bank is unlikely to lend to another bank (or any of its customers) at an interest rate lower than the rate the bank can earn on reserve balances held at the Fed. And because global reserve balances are currently plentiful, if a bank wants to borrow reserve balances, it will likely be able to do so without having to pay a rate well above the interest rate paid by the Fed. Typically, changes in the FOMC’s target for the federal funds rate are accompanied by commensurate changes in the interest rate paid by the Fed on bank reserve balances, prompting the federal funds rate to rise. adjust to a level consistent with the FOMC’s objective. .
So, initially, when the Fed wants to raise interest rates, it raises the interest rate it pays on bank reserves. For this policy to work, there must be “abundant” bank reserves. As Ennis and McMillan write:
The idea is for the Fed to maintain a balance sheet large enough to accommodate the growth of currency in circulation plus a sufficient amount of bank reserves. “Ample” means that the reserves are abundant enough not to yield a significant commodity yield. In other words, banks should value marginal unit of reserves for interest on the reserves they earn, but not because this marginal unit facilitates the day-to-day operations of the bank that holds it significantly.
What does this “enough but not too much” language actually mean? They suggest that the goal should be to get bank reserves return to their level around 2019, before the Fed’s asset ramp-up during the pandemic. (Seems to be a common view at the Fed: for example, scroll down and see similar comments from Christopher Waller.) Here’s an illustrative number with their calculations through 2029.
For our purposes, here are the important lines. The top line shows the total holdings of Fed assets, as shown above. The light blue lines show the bank reserves actually held; the red line shows their calculation of “minimum sufficient reserves”. You can see their projection that bank reserves will decline over the next two years until they reach the “ample minimum” level. The bottom orange TGA line shows the “Treasury General Account” at the Fed: you can see how it bounced back at the start of the pandemic, when the Treasury wanted to have cash to make the payments as the law dictated and emergencies, but then falls again.
All of this raises two questions. The first question is practical: how does the Fed intend to achieve this? The answer is that because the Fed receives interest payments on the Treasury debt and mortgage-backed securities it holds, it will not reinvest that money in new debt. Thus, the value of the debt he holds will decrease over time. Ennis and McMillan estimate that this process will reduce Fed debt holdings by about $80 billion per month. Thus, the “sufficient” level of bank reserves would be reached around 2026.
The second question is more difficult: is this objective of reducing Fed assets the right one? Here it should be emphasized that the political goals have been shifted. In 2013, you will recall, Aldolfatto and Li claimed that the first wave of quantitative easing was not about “monetizing debt” because it was not a permanent step and the debt held by the Fed was gradually scaled down. It was now 2023, and even if the Fed manages to stick to its plan to gradually reduce its holdings of Treasury debt over the next three years, the Fed’s total assets would still be around 7 trillion dollars by 2029. What looked like a slow phase- The decline in Fed assets in 2013 will begin to look like a permanent and generally rising trend in Fed assets by 2029, which was the working definition of debt monetization.
I don’t see an easy choice for the Fed here. The prospect of a central bank deciding to proceed with a large-scale sale of its own country’s debt would not be a good idea in the financial markets. But the approach of reducing debt held by the Fed by not reinvesting interest payments on debt held by the Fed is slow. In my view, the Fed seems to be hoping that after experiencing two unique events in the past 15 years – the Great Recession of 2007-2009 and then the pandemic recession – it simply won’t feel the need to do quantitative easing (or “monetize the debt?”) over the next decade.