Why the Nation's Central Bank Is Making the Government Debt Worse
By Kimberly Amadeo Updated July 14, 2017
A nation monetizes its debt when it converts debt to credit or cash. It frees up capital that's locked in the debt and puts it into circulation. The only way it can do this is with its central bank. The central bank purchases the government debt and replaces it with credit. The bank puts the debt on its balance sheet. It creates the credit out of thin air. A central bank is the only bank that can legally do this.
The Federal Reserve monetizes the U.S. debt when it buys U.S. Treasury bills, bonds and notes. When the Federal Reserve purchases these Treasurys, it doesn't have to print money to do so. It issues credit to the Federal Reserve member banks that hold the Treasurys. It then puts the Treasurys on its own balance sheet. It does this through an office at the Federal Reserve Bank of New York. Everyone treats the credit just like money, even though the Fed doesn't print cold hard cash.
This process is called open market operations. The Fed uses this tool to raise and lower interest rates. It lowers interest rates when it buys Treasurys from its member banks. The Fed issues credit to the banks. They now have more reserves than they need to meet the Fed's reserve requirement.
Banks will lend these excess reserves, known as fed funds, to other banks to meet the requirement. The interest rate they charge each other is the fed funds rate.
Banks will lower this rate to unload these excess reserves.
How the Fed Monetizes the Debt
How does this monetize the debt? When the U.S. government auctions Treasurys, it's borrowing from all Treasury buyers. These include individuals, corporations and foreign governments. The Fed turns this debt into money by removing those Treasurys from circulation.
Decreasing the supply of Treasurys makes the remaining bonds more valuable.
These higher-value Treasurys don't have to pay as much in interest to get buyers. This lower yield drives down interest rates on the U.S. debt. Lower interest rates mean the government doesn't have to spend as much to pay off its loans. That's money it can use for other programs.
It is as if the Treasurys bought by the Fed didn't exist. But they do exist on the Fed's balance sheet. Technically, the Treasury must pay the Fed back one day. Until then, the Fed has given the federal government more money to spend. That increases the money supply, thus monetizing the debt.
Why Is This an Issue?
Most people didn't worry about the Fed monetizing the debt until the 2008 recession. That's because until then, open market operations weren't large purchases. Between November 2010 and June 2011, the Fed bought $600 billion of longer-term Treasurys. That was the first phase of Quantitative Easing, known as QE1.
There were four phases of the QE program that lasted until October 2014. The Fed ended up with $4.5 trillion in Treasurys and mortgage-backed securities on its balance sheet.
On June 14, 2017, the Fed said it would reduce its holdings so gradually it wouldn't need to sell them.
Once the fed funds rate reaches its target of 2.0 percent, the Fed would allow $6 billion of Treasurys to mature without replacing them. Each month it would allow an additional $6 billion to mature. Its goal is to retire $30 billion a month.
The Fed will do the same with its holdings of mortgage-backed securities, only with increments of $4 billion a month until it reaches $20 billion. (Source: "Fed Unveils Plan to Shrink Its Balance Sheet," The Wall Street Journal, June 14, 2017.)
Once the Fed starts retiring its bonds, long-term interest rates will rise further. That’s because there will be a greater supply of Treasurys on the market. The U.S. Treasury will have to offer higher interest rates on the Treasurys it auctions to convince anyone to buy them. That will make the U.S. debt more expensive for the government to pay back.
It’s a serious issue with an almost $20 trillion debt. Furthermore, the debt-to-GDP ratio is more than 100 percent. That’s beyond a safe level. It makes lenders question whether a nation can afford to repay its loans.
Why Does the Fed Buy Bonds?
The Fed's primary purpose throughout QE was to keep the fed funds rate low. Banks base all short-term interest rates on the fed funds rate. A low prime rate helps companies expand and create jobs. Low mortgage rates help people afford more expensive homes. The Fed wanted QE to revive the housing market. Low interest rates also reduce returns on bonds. That turns investors toward stocks and other higher-yielding investments. For all these reasons, low interest rates help boost economic growth.
But part of the Fed's intention could have been to monetize the debt. It’s never admitted that, but it makes sense. QE helped increase government spending and boost growth. The Treasury didn't have to raise interest rates to attract buyers. That would have depressed the economy. When the economy has fully recovered, the Fed can safely reverse its QE transactions. It will sell the Treasurys it owns.
The St. Louis Fed Disagrees
In February 2013, the Federal Reserve Bank of St. Louis issued a report that denied the Fed monetized the federal debt. It claimed that the central bank can only monetize debt if its intention is to keep the Treasurys on its balance sheet indefinitely. In other words, it would be using its power to create money out of thin air to permanently subsidize federal government spending.
Instead, former Fed Chairman Ben Bernanke explicitly said that the Fed would sell Treasurys when QE ended. Although the Fed ended QE in October 2014, it hasn't begun selling its Treasurys. When it does, interest rates will rise. The federal government will find that financing its spending will become more expensive. (Source: “Is the Fed Monetizing Government Debt?” Federal Reserve Bank of St. Louis, February 1, 2013.)