How the Fed Monetizes the U.S. Debt
Why the Nation's Central Bank Is Making the Government Debt Worse
A nation monetizes its debt when it converts debt to credit or cash, freeing up capital that is locked in the debt and putting it into circulation. The only way a country can do this is with its central bank, which purchases the government debt and replaces it with credit. In turn, the central bank puts the debt on its balance sheet.
The Federal Reserve, also known as the Fed, is the central bank of the United States, and it monetizes U.S. debt when it buys U.S. Treasury bills, bonds, and notes. When the Fed purchases these Treasuries, it doesn't have to print money to do so; it issues a credit to its member banks that hold the Treasuries by adding funds to reserve deposits. The debt then transfers from the member bank to its own balance sheet. It does this through an office at the Federal Reserve Bank of New York. The credit is treated just like money, even though the Fed doesn't print actual cash.
This process is called open market operations, and the Fed also uses it to raise and lower interest rates when it buys Treasuries 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 will then lend these excess reserves, known as fed funds, to other banks so that they can meet their reserve requirements. The banks usually offer a lower interest rate, known as the fed funds rate, to other banks so they can unload their excess reserves more easily.
How the Fed Monetizes the Debt
When the U.S. government auctions Treasuries, it's borrowing from all Treasury buyers, including individuals, corporations, and foreign governments. The Fed turns this debt into money by removing those Treasuries from circulation. Decreasing the supply of Treasuries makes the remaining bonds more valuable.
These higher-value Treasuries don't have to pay as much in interest to get buyers, and 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, and that's money it can use for other programs.
Lower interest rates mean the government doesn't have to spend as much to pay off its loans, and that's money it can use for other programs.
This process may make it seem as if the Treasuries bought by the Fed don't exist, but they do exist on the Fed's balance sheet, and 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.
Most people didn't worry about the Fed monetizing debt until the 2008 recession because, until then, open market operations weren't large purchases.
Quantitative Easing After the Great Recession
Between November 2010 and June 2011, the Fed bought $600 billion worth of longer-term Treasuries, after buying $175 billion worth of Treasuries 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 the start of 2015, the Fed ended up with roughly $4.5 trillion on its balance sheet.
Reducing the Balance Sheet
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. To that end, on June 14, 2017, the Fed said it would reduce its holdings. It planned to do so gradually by letting securities mature without replacing them on the balance sheet. That way, it wouldn't need to sell debt, but it could still reduce its balance sheet. The process began in October 2017 and continued until September 2019.
Some people believe that this program was damaging because it could cause long-term interest rates to rise. As a greater supply of Treasuries re-entered the market, the U.S. Treasury had to offer higher interest rates on the Treasuries it auctions to convince anyone to buy them. That makes the U.S. debt more expensive for the government to pay back. People also believed that this program removed liquidity from the market and could indirectly impact stocks around the world.
Debt Buying in 2020
On March 15, 2020, the Federal Reserve announced that it planned to gradually spend at least $500 billion on additional Treasury securities. Other Fed measures included a plan to purchase up to $750 billion worth of corporate debt, including high-yield bonds and corporate debt ETFs.
Why the Fed Bought Bonds
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.
Federal Reserve Banks of St. Louis. "How the Fed Is Reducing Its Balance Sheet—and Why." Accessed April 9, 2020.
Federal Reserve Bank of St. Louis. "Quantitative Easing: How Well Does This Tool Work?" Accessed April 9, 2020.
Board of Governors of the Federal Reserve System. "Recent Balance Sheet Trends." Accessed April 9, 2020.
Federal Reserve Bank of St. Louis. "In-Depth: Is the Fed Monetizing Government Debt?" Accessed April 9, 2020.
Board of Governors of the Federal Reserve System. "FOMC Issues Addendum to Normalization Principles and Plans." Accessed April 9, 2020.
Board of Governors of the Federal Reserve System. "Implementation Note Issued September 20, 2017." Accessed April 9, 2020.
Board of Governors of the Federal Reserve System. "Balance Sheet Normalization Principles and Plans." Accessed April 9, 2020.
Board of Governors of the Federal Reserve System. "Implementation Note Issued March 15, 2020." Accessed April 9, 2020.
Board of Governors of the Federal Reserve System. "Secondary Market Corporate Credit Facility." Accessed April 9, 2020.