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The Fed and monetizing federal debt

A WSJ editorial last Friday (June 3rd) mentioned the Fed monetizing the new debt.  Then, in today's WSJ, in an op-ed by Kevin Warsh - the "Fed is monetizing the fiscal expansion" phrase came up again, along with "It (the Fed) should not tolerate Fed-financed fiscal expansion."  My question for you is mechanical.  Am I right in saying that ALL the Fed's bond purchases have been secondary market transactions?  You have written many times that the primary dealers have had no problems finding buyers for new issues - so that means the Fed is never at the head of the line at the auctions - right?  I realize that the Fed's bond buying influences interest rates, but the WSJ and their favorite op-ed writers seem to be suggesting (perhaps) that the only reason the primary dealers have had no trouble with new Treasury issues is that the buyers know that the Fed will soon buy those already purchased bonds and take them off their hands.  I am skeptical about that notion.

Hi @steve-w

This is all very technical, but the right way to think about this is that the financial flow starts with the Treasury. So, the Tsy issues new debt to spend in deficit. That bond is the net financial asset. The Tsy sells the bonds to banks (Primary Dealers) who are required to make bids for the Tsy. The Fed has no involvement in this part of the process and can only buy the bonds in the secondary market. So, the banks buy many of the bonds and on-sell them other buyers (including the Fed). So, it looks like the Fed is basically buying the bonds directly from the Tsy. Which, they kind of are. But the kicker is that the Fed just issues a low interest bearing reserve in exchange for the bond. So, what's the totality of all this?

A GREAT BIG ASSET SWAP. In other words, if the Fed/Tsy were a combined entity and the Fed had funded spending by issuing a new reserve how would that be different from the Tsy having issued the bond? Reserves are essentially a form of govt bonds by a different name. So the Fed hasn't issued a new bond. They've simply taken the existing bond out of circulation and issued a bond-like asset (the reserve) in its place.

It reminds me of the old joke I once heard on a safari:

"Do you know the difference between the ZEEBRA and the ZEBRA? A ZEEBRA is black with white stripes and the Zebra is white with black stripes."

People really think that the reserves are somehow some sort of world changing asset when they're swapped with something that has the exact same credit quality and slightly lower interest payments....Craziness. But because the operations are so convoluted people misunderstand this stuff and all.

Hope that helps.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

Thanks, Cullen.  So the primary dealers have not had any trouble with the auctions, but do you think that would be different if the Fed wasn't such a major "other buyer"?

Hi @steve-w

There's a reasonable argument that rates would be higher on some of this debt because inflation is running 3% on the PCEPI right now. So, you could definitely make an argument that the overnight rate, if it floated, would be something like 2-3%. That's how I think of it anyhow. The rate of inflation is essentially the real cost of govt funding. If the govt just printed new cash and fired it out the door the "cost" of funding that new printing is inflation. So bonds would reflect this to some degree.

So, if the Fed wasn't a thing and there was no interbank market then I guess you could make that argument. But that's not the way things are set up. We specifically have a Fed and overnight market where reserves circulate in a closed system.

If inflation were 10% and the overnight rate was 0% then I think you could make a very reasonable argument that the demand for govt bonds is low. But 2-3% inflation is basically the historical average. So there's average demand for govt bonds regardless of what the Fed is doing with one part of the interest rate curve.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche