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Home Publications Blogs Beat the Press Economists Discover that Fed Bond Purchases Affect the Budget

Economists Discover that Fed Bond Purchases Affect the Budget

Saturday, 23 February 2013 06:18

Wow, you've got to give those economists credit. As Neil Irwin tells us, they figured out that the Fed's bond purchases affect the budget. Of course they put it on the negative side, noting that the Fed stands to lose money when it sells off its bonds at a loss later in the decade if interest rates rise as projected.

There are two important points that are worth pointing out on this one. First, the Fed does not have to sell off the bonds. It can simply hold its bonds until maturity as those of us who are a few years ahead of mainstream economists pointed out a while back.

If the Fed were to go this route, it could reach its targets for restricting money supply expansion by raising reserve requirements. This shouldn't be that hard a concept to understand, the option appears in every intro textbook. While changing the base of reserves, rather than the money multiplier by changing the reserve requirement, is the preferred manner for the conduct of monetary policy, a set of higher reserve requirements scheduled long in advance should not be too disruptive to the banking system. We did use to have much higher reserve requirements. Also, China's central bank routinely uses reserve requirement changes to conduct its monetary policy.

The other point that should jump out at folks is that the projected drop in bond prices, which is the reason that the Fed is projected to lose money, presents a great opportunity for the government to reduce its debt burden. The idea is that long-term bonds issued at the current low interest rates will sell at sharp discounts later in the decade, if interest rates rise as projected.

These discounted prices will give the government the opportunity to reduce its debt by hundreds of billions of dollars -- perhaps more than $1 trillion -- simply by buying these bonds back at lower prices. Such a move would be utterly pointless since it would not change the country's interest burden at all, but since we currently live in a political environment where the debt to GDP ratio is an object of worship, this would be a great way to appease that god. It sure beats big cuts to Social Security and Medicare.

There is one other point about this piece that is worth noting. It tells readers:

"The great risk is that the political blowback from those losses would endanger the Fed’s independence." 

While the Fed deserves points for trying to boost the economy in the wake of the downturn it is hard to argue that the country has been well-served by an independent Fed. Greenspan at least looked the other way as the housing bubble grew to ever more dangerous proportions. Arguably, he even sought to fuel its growth as a way to recover from the collapse of the stock bubble.

The result has been incredibly disastrous with millions of lives being ruined by unemployment and the country likely to lose more than $7 trillion in output from the downturn. Could we really have done worse with a Fed that was more responsive to Congress? Perhaps, but it doesn't seem like we have much to lose here.


Note -- slight edits were made to an earlier verison.

Comments (14)Add Comment
written by Bart, February 23, 2013 6:50

Don't forget Greenspan's "Deflation is coming; give away the surplus!" scare that enabled Bush to cut taxes for the rich.

If that is Fed independence, I'll take a pass.
Cannot understand, Low-rated comment [Show]
Reserve Requirements and Kabuki Theater
written by Ellen1910, February 23, 2013 10:09
Changing bank reserve requirements doesn't effect economic activity and doesn't effect the amount of bank reserves in the banking system. All it does is change the name of a portion of the reserves from "excess" to "required."

A bank can "use" its reserves to make a loan; but total banking system reserves don't change because the proceeds of the loan will wind up in that same bank or another bank. Example: I borrow $50,000 from Bank A and buy a car. The dealer deposits my check in Bank B and then, uses $40,000 to pay its floor plan creditor which deposits the dealer's check in Bank C.

Bank A's reserves go down $50,000. Bank B's reserves go up $50,000. And then, down $40,000; and Bank C's reserves increase $40,000.

Someone please explain to me why changing the reserve requirement does or means anything whatever.
written by Peter K., February 23, 2013 10:24
The dishonesty displayed by economic conservatives on the issue is galling, frankly.

Appelbaum has a piece on this as well. AFAIK this is the first time I've seen the Fed confirm that it will raise the interest rate on excess reserves.


"When the economy grows stronger, the Fed plans to sell some of its vast holdings of Treasury and mortgage-backed securities. The Fed also plans to pay banks to leave some money on deposit with it to limit the pace of new lending."
I will admit
written by Ellen1910, February 23, 2013 10:27

If there were no excess reserves in the system, then, raising the reserve requirement would reduce bank lending (and economic activity).

Because under those conditions Bank A, which has no excess reserve, must borrow the full amount of its $50,000 from other banks since it used its required reserves to make the loan. But bank B and bank C can't loan the full $50,000 back to Bank A, because a portion of the $50,000 those banks received went into their RR accounts.

But today, with the huge amount of excess reserves available to support bank lending, that little scenario won't play.

Will it?
A Fed Controlled by Congress? No
written by Dennis Doubleday, February 23, 2013 10:56
Perhaps you are being a bit tongue-in-cheek about the independence of the Fed, but I would say, yes, a non-independent Fed could be much worse.

Granted that the QE practiced by the current Fed is an inadequate policy response, but is there any doubt that the last Congress would have failed to authorize even that? It would have simply been an opportunity to ensure that Obama was a failure, regardless of damage to the country.
Right, Ellen
written by Calgacus, February 23, 2013 1:55
Ellen, right, especially the first comment. Especially in current conditions. (Positive) Reserve requirements are just a tax on banks - saying that they must keep some of their assets as non-interest bearing reserves. Now that we have interest on reserves, and being in a low growth, low interest real-economy-depression the difference is even smaller.

But the presence of excess reserves in the system isn't even necessary. Raising reserve requirements wouldn't substantially constrain even then. Being a bank means you have a friend at the Fed's discount window, that you can borrow reserves on demand. Banks are capital-constrained, not reserve-constrained. And with a friendly enough Fed & other regulators, they are only constrained by what their management (looters) think they can get away with.

"The money multiplier" Dean refers to embodies a causality which reverses the real one. The (recent) textbooks he speaks of are wrong. They embody what Schumpeter called the coat-check theory of banking. The correct "loans create deposits" "endogeneous" theory was dominant from around 1920 to the 50s. But partly because the reality of postwar economies could ignore finance because of the high debt/gdp, the large amount of safe government bonds/money, and partly because the correct theory disappeared from Keynes's General Theory after prominently figuring in his Treatise on Money, the Keynesians simply forgot this. And later, courses on history and finance were purged from economics curricula, in favor of fake "economics" using fake "mathematics".
written by watermelonpunch, February 23, 2013 2:14
Perhaps you are being a bit tongue-in-cheek about the independence of the Fed, but I would say, yes, a non-independent Fed could be much worse.

Granted that the QE practiced by the current Fed is an inadequate policy response, but is there any doubt that the last Congress would have failed to authorize even that? It would have simply been an opportunity to ensure that Obama was a failure, regardless of damage to the country.

This is a matter of politics more than economics though isn't it?
Of course I recognize that they are meshed, either way.
But I'm just wondering if there's more to this than what that means...

Not sure if I can explain my question here properly though.

I mean that I assumed that it was "tongue in cheek" - a sort of joke that they couldn't have done worse than they already did. (That's an easy joke, after all.)

But I'm thinking Irrelevant Thesis might come into play here:
"is there any doubt that the last Congress would have failed to authorize even that? It would have simply been an opportunity to ensure that Obama was a failure, regardless of damage to the country."

Sounds likely to me. But do we know?
I guess that's my question.
Is there more that could've come into this to consider?
Hi Calgacus
written by Ellen1910, February 23, 2013 6:23
I agree that banks don't need reserves to make loans, but what about the situation where -- for whatever reason -- there are no excess reserves in the system. And as in my example and by definition the loan will not generate enough interbank loan funds to fully replace the original lending bank's reserve draw down. The lending bank must go to the "discount window."

At that point the Fed is free to raise the discount rate to pretty much whatever it wants; banks will have to raise their loan rates to afford the discount window costs; fewer projects will prove economic at these higher rates; and business activity will decrease.

Instead of selling bonds to raise interest rates on instruments which compete with bank loans for finance capital, the Fed goes after the banks, directly, and their customers, indirectly.

I think that's how raising the reserve requirement enough to eliminate excess reserves would work. And the FOMC could be put out to pasture.
written by urban legend, February 23, 2013 9:00
"Arguably, he even sought to fuel its growth [the housing bubble] as a way to recover from the collapse of the stock bubble."

It has always seemed to me that he looked the other way because the Bush tax cuts, top-heavy as they were, made little contribution to growth. The stock market collapse had already played itself out, and that bubble was never nearly as central to the economy as the housing bubble was. Greenspan knew the housing bubble was the only way to keep employment from collapsing, especially when we were missing 3 million or so jobs that should in a self-sustaining economy have been engaged in maintaining a modern infrastructure and keeping it up to date compared to other advanced countries.
written by Chris Engel, February 23, 2013 11:33

Maybe instead of reserve requirements paying a higher IOR will help mop up liquidity in the same way?

Unfortunately Dr. Baker actually does make reference to a gold-era concept of the money multiplier. You correctly point out that this is an outdated concept which Krugman even admits "textbooks need to be rewritten to accomodate" the reality of chartalism in our fiat system.

Dr. Baker otherwise has many good points on the general topic of not being a debt-fear-monger or a deficit-hawk.

But in the current situation with excess reserves I'd say that reserve requirements aren't sufficient alone, perhaps adjusting the incentive options with a higher IOR payout would mop up the liquidity at a lower price than selling off bonds. (I'm not sure, just trying to add another idea into the discussion, maybe Dr. Baker can shed more light on this).

To Dr. Baker,

You make great points on the debt, but one area where I still find some disagreement with you are the points made by neo-chartalists.

Banks don't need reserves to make loans, this is an old gold standard textbook thing that is really not correct anymore. As a result, the money multiplier does NOT hold. Loans create deposits. Deposits do not create loans.

Simon Wren-Lewis from Oxford on his blog MainlyMacro has a discussion here:


so reserve requirements are still a valid way to conduct monetary policy, but as others in this thread have pointed out, with excess reserves present it complicates things and there are still cheaper options outside of selling bonds at a loss for the Fed to conduct tightening.

Although, I find this entire conversation (not started by you, but that you're responding to from economists scared about rates going up) kind of silly when we're flirting more with a Japanese-style deflation than any kind of run-away inflation. Let's worry about high rates when we actually get the growth and inflation that will lead to the high rates.

Also isn't it possible that the Fed can engage in some kind of derivative-hedging to help offset the risk of higher rates? Or would the Fed participating in any private-derivative market like that just spook absolutely everyone who is "in the know" ?

To Bart,

The federal surpluses we ran under Clinton were worst economic policy of the post-stagnation period of the 70's.

What happens when we are the world reserve currency? We run huge current account deficits.

What happens when we run federal surpluses while the current account is in a steep deficit? We get a growing and steep PRIVATE SECTOR DEFICIT.

That means balancing the budget or running surpluses is horrible economic policy, because:

1) We need to constantly have new debt to expand the money supply. The Fed creates reserves to buy primarily Treasury debt (lately that has changed to other private assets, but that aside...), so we need a constant flow of debt. And since we print hte money default isn't a problem, it's just a reality of our monetary mechanics.

2) With a massive trade deficit, a balanced public budget only forces the private sector into a nasty deficit.

written by Bruce Krasting, February 24, 2013 6:27
The author suggests that a windfall is in the country's future when interest rates rise. He thinks the US will be able to "buy back" debt at a discount.

Clearly the author does not know how this works. The government can't buy its debt, and even if they could, what would they "buy" the debt with? It would have to be with more expensive debt. So there is no "windfall" that could come from higher interest rates.

If US rates did go back up, it would rip the country apart. How could someone think there was an "upside" to that scenario?
written by Chris Engel, February 24, 2013 7:42
The author suggests that a windfall is in the country's future when interest rates rise. He thinks the US will be able to "buy back" debt at a discount.


You're the only one using the term "windfall".

Re-read Dr. Baker's entire entry, he makes quite clear how pointless such an idea would be, but it helps expose the absurdity of freaking out over the government debt too.

The debt/gdp level is not some holy marker, but if people insist on using it as one, we can reduce the outstanding notionals with such gimmicks.

Debt is the fabric of our monetary system, Treasuries are how the Fed conducts monetary policy and how dollars are distributed throughout our society.

There's numerous ways that operationally the government could achieve this "buy back" between executive agencies, the Federal Reserve (which is the federal government anyway), and primary dealers to "middle" the whole thing (as by law this is required). But the details don't matter because it's absurd really to worry about it in the first place!
Still not a fan of FED floating markets with liquidity
written by Peter, February 24, 2013 1:06
Good analysis. Absolutely right that this would be a great chance for government to buy back bonds. But in the mean time they need to pay higher interest rates as well. So yes the might back some bonds but on the other hand the monthly interest rate payments would increase sharply on the still excisting debts http://www.youtube.com/watch?v=MNbRIx2rsrk

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.