Economists Discover that Fed Bond Purchases Affect the Budget

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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.