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The Biggest Myth About the Fed

There many myths about Fed policy over the past few years, but the biggest one has to be that the Fed has been monetizing the national debt.  This simply is not true, but it does not stop some folks from making this claim.  For example, at last week’s Cato Monetary Conference we find former Fed officials pounding the Fed-is-monetizing-the-debt drums:

Mr Warsh and Mr Poole (who was filling in for Allan Meltzer) made a sharp distinction between the “legitimate” efforts to fight the crisis and the subsequent easing actions that were, allegedly, unjustified by the economic fundamentals. According to them, the interventions of 2007-2009 were required to ensure that “the markets could clear”, as Mr Warsh put it, while the second round of easing was done to satisfy “political masters” by monetising the debt. In fact, Mr Warsh said that the Fed was being actively unhelpful by “crowding in” Congress’s supposedly poor policy choices.

My first response is how can they can say this with historically-low U.S. treasury yields and muted inflation expectations? Surely, if the Fed were truly monetizing the debt we would be seeing a 1970s-repeat in the bond market, but we are not.  And this is happening, in part, because the Fed is not that big of a treasury purchaser.  Consider the figure below.  It shows the Fed’s stock of treasuries by remaining maturity compared to the total stock of marketable treasuries as of the end of October, 2012.  Though the Fed’s share of treasuries increases by remaining maturity, at most it hits 32% of the total for 10-30 years category. That means that after many months of Operation Twist that roughly 68% of long-term treasuries are still held outside the Fed. Overall, the Fed holds about 15% of marketable treasuries as seen in the “All Years” category.  It is hard to square these numbers with the allegations that the Fed is monetizing the debt.

 

Some commentators like to focus on the change in treasury holdings in 2011 because it sounds so scary.  Here is Arnold Kling:

In 2011, the Federal Reserve bought 77 percent of new debt issued by our government. We are already resorting to inflationary finance.
While the Fed did purchase a large share of new treasuries in 2011, these purchases only returned the Fed’s share of total marketable treasuries to its pre-crisis level as seen below.  Again, not exactly a picture of debt monetization.

 

So stop accusing the Fed of monetizing the debt and enabling the large budget deficits.  And stop blaming the Fed for the long decline in treasury yields.  If anything, blame the Fed for allowing treasury interest rates to fall, but that is a different story.

This piece is cross-posted from Macro and Other Market Musings with permission.

5 Responses to “The Biggest Myth About the Fed”

BurkNovember 21st, 2012 at 10:35 am

Could someone explain the argument being made here? The Fed purchases boatloads of government bonds and MBS's and a great deal else, (while private purchasers are buying more), and is pumping out money, all in an effort to lower interest rates. And this is not to some degree monetizing the deficits? I thought issuing lots of money and lowering interest rates was the whole point, in part by gobbling up treasury debt. Just because the private market is risk averse and also gobbling up debt doesn't (seem to) mean that the Fed isn't also funding the treasury.

I would speculate that the real argument is that the debt bought by the Fed is not being retired. It has no intention of burning these bonds, but rather plans to re-sell them when conditions warrant. Thus no permanent monetization. Is that closer to the truth?

b...November 27th, 2012 at 4:23 am

Absolutely correct and spot on Burk – "monetizing" government-backed paper is exactly what central banks do – it's how we get money. Folks seem to confuse that with "debasement" – which would be to print money against nothing and give it away – or indeed as you point out, to buy government paper and to "burn it"/ forgive it. Yes the Fed is aiding government borrowing somewhat, but the government still has to repay that borrowing – no matter how advantageous the interest rate. The real issue is not so much that the Fed is ading the government, it is that it is unable to stoke any meaningful private sector credit growth – which is based upon the government yield curve. That's certainly no surprise to any one with any common sense, but it seems to be to the Fed and its gaggle of commentators. This raises the question: "If you can't stoke private sector credit growth, why bother??".

fresno danNovember 27th, 2012 at 8:24 am

I mostly agree with you. But I find it hard to believe that the debt bought by the Fed will EVER be able to be sold at other than a substantial loss. The question I have is: How will that loss be disguished?

ThomasNovember 27th, 2012 at 10:57 am

Doesn't the Fed return to the Treasury all payments on the US debt it buys? If so, then how could this not be monetization? Perhaps the argument is that the purchases are not so large as to cause substantial debasement. Also, what about the argument that we are having inflation in assets, just not the prices that show up in the CPI? Finally, is there a concern that this is cronyism at its worse, as the big banks and other insiders can game the Fed's system?

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