I’ve argued quite vehemently that I don’t think the Fed is monetizing the debt. At least not in the sense that most people refer to it as monetizing the debt. And I think it’s a very important distinction.
There’s a tendency in some circles to commingle monetary policy and fiscal policy. With QE, it looks like the Fed is directly financing the US Treasury since it is basically buying bonds on the secondary market some of which were only just recently auctioned. And those who imply the Fed is monetizing the debt are usually doing so in order to validate the theory that the Fed is needed to finance the deficit. As if there wouldn’t be enough buyers of government debt if the Fed weren’t stepping in. I took the other side of some rather prominent pundits at that time who said there wouldn’t be enough buyers of bonds when QE2 ended and that rates would rise as a result. That didn’t happen. In fact, rates tanked and bond auctions remained extremely strong. So, I think it’s better to separate monetary policy and fiscal policy or we’re likely to make similar mistakes going forward.*
QE is part of monetary policy and simply involves the Fed buying bonds on the secondary market. The Fed swaps deposits/reserves for bonds and hopes to have a number of positive impacts on the private sector. Closely related is the Fed’s ability to control interest rates (also monetary policy). That is, if the Fed wants to keep the 10 year from spiking, as the reserve monopolist, it can simply set the rate where it wants. They’re not doing that, but there’s an indirect effect by setting the overnight rate. In other words, the long rate is a reflection of the short rate and where the Fed sees future policy. The market will naturally try to front-run the Fed if they forecast a tighter policy move or an environment where the Fed might be forced to tighten.
When some people try to claim the Fed is financing the government they’re implying that this low rate environment is only sustainable due to an artificial demand from the government and that bond vigilantes might attack or the government might be unable to fund its spending without the Fed stepping in. I often point to the market reaction and very strong bond auctions after QE2 ended as real-time evidence that this is wrong, but that’s not always enough to prove my point.
Anyhow, the more interesting debate here is whether the Fed really believes they’re needed to fund the deficit and keep rates low? There are conflicting comments on this subject over the years. But it’s probably not a coincidence that the size of QE has closely tracked deficit spending. So, it’s interesting to think – if the deficit is falling substantially then perhaps the Fed sees its program as unnecessary. That is, with a deficit that is shrinking 25% versus last year, then maybe the Fed thinks QE can be 25% percent smaller. And if that’s the case then no one should be surprised by all this “tapering” talk.
It’s all extremely interesting to me, because I think so much of the understanding of QE is wrong to begin with. So, what if the entity running the program actually believes it’s needed to fund the deficit and plans on removing this huge psychological put from underneath the market based on what I think is a misconception? The falling deficit and the removal of the Bernanke Put….Talk about a potential double whammy….
* See my primer on QE here if you’re confused already….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.