The financial crisis and Great Recession have magnified public scrutiny of the Federal Reserve, a consequence of the extraordinary actions the Fed has taken since 2008.
Among the Fed’s actions—specifically those by the FOMC (Federal Open Market Committee), the Fed’s monetary policymaking body—has been the increase of the U.S. monetary base. Since August 2008 the Fed has tripled the monetary base from about $0.8 trillion to $2.7 trillion, of which $1.2 trillion was used to purchase U.S. government bonds (i.e., Treasury debt).
As St. Louis Fed economist David Andolfatto and research associate Li Li explore in a recent Economic Synopses, this has led some commentators to argue that the Fed is “monetizing government debt.” Essentially, the concern is that the Fed is somehow enabling excessive government borrowing and possibly risking future inflation.
Defining “Monetizing Debt”
To be clear about what “monetizing the debt” means, Andolfatto and Li review some basic principles. The Fed is required by mandate to keep inflation low and stable and to stabilize the business cycle to the best of its ability. The Fed fulfills its mandate primarily by open market sales and purchases of (mainly government) securities. If the Fed wants to lower interest rates, it creates money and uses it to purchase Treasury debt. If the Fed wants to raise interest rates, it destroys the money collected through sales of Treasury debt. Consequently, there is a sense in which the Fed is “monetizing” and “demonetizing” government debt over the course of the typical business cycle.
However, what is usually meant by “monetizing the debt,” Andolfatto and Li write, is the use of money creation as a permanent source of financing for government spending. Therefore, whether the Fed is truly monetizing government debt depends on what the Fed intends to do with its portfolio in the long run.
Federal Reserve Holdings of U.S. Marketable Securities
Click to enlarge
SOURCE: Federal Reserve Board
NOTE: Shaded areas indicate U.S. recessions.
Is It a Permanent or Temporary Increase?
In an October 2012 speech to the Economic Club of Indiana, Fed Chairman Ben Bernanke explained that ultimately what the Fed is doing is little different than what it has always done. “The Fed’s basic strategy for strengthening the economy—reducing interest rates and easing financial conditions more generally—is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.”
For example, the FOMC has made unusually large acquisitions of longer-term securities, including Treasury debt. But is this debt a permanent acquisition? Or will its stay on the Fed’s balance sheet be temporary? Andolfatto and Li address these questions:
- Permanent – If this accumulated Treasury debt is supposed to be permanent, then it is reasonable to expect that the corresponding supply of new money would also be permanent and would remain in the economy as either cash in circulation or bank reserves, Andolfatto and Li write. As the interest earned on the securities is remitted to the Treasury, the federal government essentially can borrow and spend this new money for free. Thus, under this scenario, money creation becomes a permanent source of financing for government spending.
- Temporary – On the other hand, if the Fed’s recent increase in Treasury debt holdings is only temporary (an unusually large acquisition in response to an unusually large recession), then the public must expect that the monetary base at some point will return to a more normal level—with the Fed selling the securities or letting them mature without replacing them. Under this scenario, the Fed is not monetizing government debt—it is simply managing the supply of the monetary base in accordance with the goals set by its dual mandate. Some means other than money creation will be needed to finance the Treasury debt returned to the public through open market sales.
Bernanke has repeatedly propounded the latter view, for instance in his aforementioned speech, Andolfatto and Li explain. They also write that the credibility of Fed policy is arguably reflected in the course of inflation and inflation expectations. Since 2008, inflation has averaged less than the Fed’s official long-run inflation target of 2 percent per year. Moreover, market-based measures of inflation expectations remain well-anchored. So, it seems that to this point, at least, the Fed’s credibility is passing the market test.
Meanwhile, Andolfatto and Li write that the claim that Fed policy is exerting downward pressure on interest rates, especially at the short end of the yield curve, has some merit. The quantitative impact of Fed policy on longer rates, however, is debatable. The reason for this is because an elevated worldwide demand for U.S. Treasury securities is keeping yields low independently of Fed policy. The possibility that forces outside the Fed have a large impact on yields is suggested by the data in Figure 1 below. As the figure shows, the vast majority (85 percent) of marketable U.S. Treasury debt is held outside the Fed and is close to the average ratio held over the past 20 years.
So, is the Fed monetizing debt—using money creation as a permanent source of financing for government spending? The answer is no, according to the Fed’s stated intent. In a November 2010 speech, St. Louis Fed President James Bullard said: “The (FOMC) has often stated its intention to return the Fed balance sheet to normal, pre-crisis levels over time. Once that occurs, the Treasury will be left with just as much debt held by the public as before the Fed took any of these actions.” When that happens, it will be clear that the Fed has not been using money creation as a permanent source for financing government spending.
- Most of the remaining new money has been used to purchase mortgage-backed securities.
- “Is the Fed Monetizing Government Debt?” by David Andolfatto and Li Li, Federal Reserve Bank of St. Louis Economic Synopses, 2013, No. 5.
- “Five Questions about the Federal Reserve and Monetary Policy,” speech by Ben Bernanke delivered to the Economic Club of Indiana, Indianapolis, Oct. 1, 2012.
- “QE2 in Five Easy Pieces,” speech by James Bullard delivered at the High Profile Speaker Series, New York Society of Security Analysts, New York City, Nov. 8, 2010.