How Is the Fed Monetizing Debt?

monetize the debt
When the Fed buys U.S. Treasuries, it allows the government to borrow more while keeping interest rates low.. Photo: Katrina Charmatz/Getty Images

The Federal Reserve monetizes debt any time it buys U.S. Treasuries. When the Federal Reserve buys these Treasuries, it doesn't have to print money to buy them. It issues credit and puts the Treasuries on its balance sheet. Everyone treats the credit just like money, even though the Fed doesn't print cold hard cash.

The Fed doesn't buy Treasuries directly at auction. Instead, it purchases them from its member banks.It does this through an office at the Federal Reserve Bank of New York.

How does this monetize the debt? The U.S. government borrows when it auctions Treasuries. It's taking a loan from all buyers, including individuals, corporations, and foreign governments. The Fed turns this debt into money by removing those Treasuries from circulation. That decreases the supply of Treasuries, making the remaining Treasuries more valuable.

Treasuries that are more valuable 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.

The net effect is that it is as if the Treasuries 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. That's called monetizing the debt.

The Fed monetizes the debt whenever it engages in its open market operations.The Fed has always used this tool to raise and lower interest rates. It lowers interest rates when it buys Treasuries 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. 

Most people didn't worry about the Fed monetizing the debt until the recession. That's because prior open market operations weren't large purchases. The Fed bought $600 billion of longer-term Treasuries between November 2010 and June 2011. That was the first phase of Quantitative Easing, known as QE1.

Why Does the Fed Buy Bonds?

The Fed's primary purpose in all phases of QE was to keep the Fed funds rate, and all interest rates, low. That helps companies expand, creating jobs. Low-interest rates also help people afford expensive homes. Therefore, the Fed was trying to revive the housing market. Low-interest rates also reduce returns on bonds. In time, investors look for stocks and other higher-yielding investments.

For all these reasons, low-interest rates help boost economic growth.

However, part of the Fed's intention probably was to monetize the debt. That helped the Treasury increase government spending and boost growth. It didn't have to raise interest rates, which would depress the economy. Eventually, it will reverse the transaction and get the Treasuries off of its balance sheet. At that time, it will remove the credit from the Federal government's operating budget.

The St. Louis Fed Disagrees

In February, the Federal Reserve Bank of St. Louis issued a report that denies the Fed is monetizing debt. The central bank can only monetize debt if its intention is to keep the Treasuries 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, Fed Chairman Bernanke explicitly said that the Fed would sell Treasuries when Quantitative Easing ended. Although the Fed ended QE in October 2014, it hasn't begun selling its Treasuries. When it does, interest rates will rise. The Federal government will find financing its spending to become more expensive. (Source: Federal Reserve Bank of St. Louis, Is the Fed Monetizing Government Debt?, February 1, 2013.) 

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