How the Fed Monetizes the US Debt
A nation monetizes its debt when it converts debt to credit or cash.
The only way a country can do this is through its central bank, which can purchase the government debt and replace it with credit. In turn, the central bank puts the debt on its balance sheet. Critics tend to call the policy "monetizing the debt" because it enables excessive government borrowing.
The Federal Reserve is the U.S.'s central bank. It monetizes U.S. debt when it buys U.S. Treasury bills, bonds, and notes from member banks. The Fed doesn't have to print money to do so. Instead, it issues a credit to the bank's reserve deposits. The credit is treated just like money, even though the Fed doesn't print actual cash. This process is called open-market operations.
The Fed also uses open-market operations to raise and lower interest rates when it buys Treasurys from its member banks. The Fed issues credit to the banks, leaving them with more reserves than they need to meet the Fed's reserve requirement. The banks then lend these excess reserves, known as fed funds, at a lower rate to other banks so that they can meet their reserve requirements.
How the Fed Monetizes the Debt
When the U.S. government auctions Treasurys, it's borrowing from all Treasury buyers, including 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. The resulting 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 the interest on the debt, and that's money it can use for other programs.
This process may make it seem as if the Treasurys bought by the Fed don'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, increasing the money supply, and monetizing the debt.
Debt Monetization and Quantitative Easing
Concerns about the Fed monetizing debt arose after the 2008 recession when the central bank launched quantitative easing (QE), which is an open-market operation strategy. From November 2010 and June 2011, the Fed bought $600 billion of long-m Treasurys after buying $175 billion worth of Treasurys between December 2008 and March 2010. Those were the first and second phases of quantitative easing, known as QE1 and QE2. A third phase, QE3, ended in October 2014. By 2015, the Fed had $4.5 trillion on its balance sheet.
Once the economy improved, the Fed ended QE and returned its balance sheet to normal. To that end, in June 2017 the Fed said it would reduce its holdings by gradually letting securities mature without replacing them on the balance sheet. That way, it wouldn't need to sell debt, which could cause interest rates to rise. The process began in October 2017 and continued until September 2019.
The Fed renewed QE during the 2020 recession caused by the COVID-19 pandemic. On March 15, 2020, the central bank announced that it would purchase at least $500 billion of Treasurys a month.
The Fed also purchased up to $750 billion worth of corporate debt, including high-yield bonds and corporate debt ETFs.
On March 23, 2020, the Fed expanded QE purchases to an unlimited amount. By May 18, its balance sheet had grown to more than $7 trillion. As long as it sits on the Fed's balance sheet, it is monetizing the debt. The Fed has turned that debt into money that banks can lend to borrowers.
Spurring the Economy or Monetizing the Debt?
The Fed argues that it isn't monetizing debt, because the Treasury debt will only sit on the Fed's balance sheet for a temporary period. If the Fed intended to truly monetize the debt, it would allow the Treasurys to sit on its balance sheet permanently. Instead, the Fed chairs have consistently announced that QE is a temporary measure to stabilize the economy through unusual times.
The Fed also points out that its purchases of Treasurys are a small percent of securities outstanding. With that in mind, the Fed's purchases don't have a large impact on the debt or the decisions of Congress to spend more and expand it.
The Fed's primary purpose throughout QE was to lower interest rates and spur economic growth. Banks base all short-term interest rates on the fed funds rate. A low prime rate helps companies cheaply borrow money so they can expand and create jobs, and 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, which turns investors toward stocks and other higher-yielding investments. For all these reasons, low interest rates help boost economic growth.