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FT Alphaville presents a guest post from Jerry H. Tempelman, CFA, who was previously a Senior Financial and Economic Analyst with the Federal Reserve Bank of New York. The views expressed are strictly his own.
In light of the continuing sluggish pace of the economic recovery, some market observers have suggested that the Federal Reserve step up its purchases of long-term Treasury securities beyond the small, symbolic move announced earlier this month. The goal would be to inject additional liquidity into the economy, perhaps as much as $2,000bn.
But it is highly unlikely that the Fed will go ahead and implement such a programme because Treasury purchases of that magnitude would begin to monetise US government debt, something Fed Chairman Ben S. Bernanke and other Fed officials have publicly stated they will not allow to happen. Furthermore, large-scale purchases of Treasury securities beyond those already announced would be unlikely to accomplish their intended objective of stimulating the economy.
When the Federal Reserve began purchasing Treasury securities in March of last year, market participants were initially concerned that the Fed would end up monetising federal government debt. Debt monetisation occurs when a central bank prints money to pay off its government's debt. The result is a larger amount of money in the system chasing an unchanged amount of goods, which causes inflation. Last year, however, these concerns were not realised, simply because the Fed did not buy enough Treasury securities for debt monetisation to happen.
The Federal Reserve has owned Treasury securities ever since it began operating in 1914. Purchasing Treasury securities is how the Fed injects monetary reserves into the banking system, at the moment when it pays for those securities. Historically, there has been a close relationship between the amount of Treasuries the Fed owns and the amount of currency in circulation. This is a form of what economists call seigniorage. A government can print as much in currency as an economy needs to function — that is, for people to make payments when conducting transactions.
Any amount of currency a government prints because it is needed this way, does not need to be taxed. If it prints more, inflation will result. But as long as the Fed does not buy more in Treasury securities than there are dollar bills outstanding, there will be no debt monetisation.
In the summer of 2007, after the onset of the global financial crisis, the Fed began swapping a substantial amount of its Treasury securities for other holdings, such as mortgage-related securities and other forms of credit, in order to provide support to specifically targeted sectors of the credit markets, which were then temporarily in disarray. Thus, when the Fed began buying Treasuries again last year, its holdings were well below the amount of currency outstanding, and no debt monetisation occurred.
In early 2007, before the crisis began, there was just over $800bn in currency in circulation, and the Fed owned roughly the same amount in Treasury securities. By March 2009, currency in circulation had grown to $900bn, while the Fed's holdings of Treasury securities had shrunk to $475bn. Today, the Fed owns $777bn in Treasuries, while currency in circulation has grown to just under $950bn.
The Fed’s room for manoeuvre
Assuming that currency will continue to grow at a normal pace, the Fed has room to buy roughly $200bn in Treasuries by the end of next year. Earlier this month, it announced it would do so by investing the proceeds of its maturing mortgage-related securities into Treasuries. This is unlikely to lead to debt monetisation, but for larger amounts (say, $2,000bn or so) that would be different. For all intents and purposes, any amount of Treasury purchases in addition to what the Fed has announced to date would result in debt monetisation.
Commentators who advocate large-scale purchases of Treasury securities by the Federal Reserve argue that generating inflation is exactly the point. Such purchases are intended to avoid a repeat of the debilitating deflationary spiral that occurred during the Great Depression. But this view overlooks what we learned in the 1960s and 1970s, namely that creating just a little bit of inflation for the sake of boosting economic growth and reducing unemployment simply does not work. Abundant credit and liquidity are necessary conditions for economic recovery, but not sufficient ones. The old "pushing on a string" analogy applies: it's much easier for monetary policy to slow down economic activity and inflation than it is to increase them.
The idea behind a policy of low interest rates is that low rates make saving less worthwhile and thus encourage consumption. Economists call this the substitution effect: changes in peoples' overall budget allocations are influenced by changes in relative prices. But that ignores what is called the income effect: lower interest rates mean that people now need to save more in order to meet their retirement objectives. It is not clear beforehand which of the two effects dominates, but the income effect has surely been much stronger than monetary policymakers realized when they began the ultra-low interest-rate policy.
Due to the Fed's efforts to date, plenty of liquidity remains in the system. Banks have more than $1,000bn in idle balances on deposit in their accounts at the Federal Reserve.
Attitudes are changing
Corporations have been able to issue debt in record amounts, but they are waiting to invest the proceeds until they have greater visibility for a positive economic outlook. Private equity firms are flush with cash but are finding only few investment opportunities they consider undervalued. Because of the Fed's purchases of mortgage-related securities, there is now even a shortage of investable high-quality mortgage-backed securities. Supply of liquidity is not what is holding back the recovery. If the supply of credit and liquidity were truly constrained, interest rates on anything from money market instruments to corporate debt to home mortgages would not be at such rock-bottom levels.
The real issue today is the demand for credit. Consumers are reducing their debt and spending levels, having found out to their chagrin that buying stuff on credit meant that they often ended up purchasing things they could not really afford. In the long run, it is a good thing if people live within their means, even if in the short run it means that the turn-around may not be as quick as we'd like it to be. Far better for the recovery to be sustainable than for it to be built on a credit bubble similar to the one we constructed the last time around after the 2001 recession.
The Fed has essentially done all it can. Now any remaining imbalances just need to wring themselves from the system. Given enough time, that will happen.
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