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Home Publications Blogs Beat the Press Why Is It Unsustainable for the Fed to Continue to Hold Financial Assets?

Why Is It Unsustainable for the Fed to Continue to Hold Financial Assets?

Tuesday, 22 June 2010 21:30

David Leonhardt had a thoughtful piece about the Fed's decision to accept higher rates of unemployment rather than engage in more aggressive quantitative easing to boost the economy. At one point he asserts that:

"There is a direct analogy between the budget deficit and the Fed’s
asset holdings. Neither is sustainable. Congress needs to
demonstrate that it has a plan for reducing the deficit over the long
haul so that investors will be confident enough to continue lending
the United States money at low rates.

The Fed, meanwhile, has to show it has a strategy for selling the
trillions of dollars of assets it bought during the crisis — without
damaging the value of private investors’ holdings and without, at
some point, igniting inflation."

It is not clear that why continued holding of assets is unsustainable. Japan's central bank has been holding vast amounts of the government's debt for more than a decade and yet it is still in the situation of fighting deflation. In the context of sustained economic weakness there is no obvious way that holding government assets will lead to inflation.

Furthermore, even if the economy was to rebound, the Fed has other mechanisms for preventing inflation, such as raising reserve requirements, which can allow it to continue to hold assets without causing inflation. This is an important point because it means that the debt accrued in the midst of a severe downturn need not impose a substantial interest burden on the government in future years. The interest on government bonds held by the Fed is rebated to the Treasury, creating no net cost to the government. There is no obvious reason why the Fed can't hold a substantial amount of the debt accrued during the downturn indefinitely while using other mechanisms to stave off inflation.

Comments (5)Add Comment
RE: There is no obvious reason...
written by Amileoj, June 22, 2010 11:18
Indeed - an excellent point. We could also go a step farther and say that there is no obvious reason why deficits run during a downturn need be accompanied by new debt issuance in the first place.

Both observations make the fundamental point that the federal government does not in fact "finance" its spending via taxation and borrowing in the money market. It simply spends, and then borrows, or not, ex post, to achieve other goals (e.g., interest rate maintenance).

It would be nice if more economists could bring themselves to concede that rather obvious truth instead of cloaking it in a lot of obfuscatory nonsense about what government can and cannot "afford" to do, as though such a hard financial constraint, as opposed to prudential concerns about possible inflation, actually existed in reality.
what, no new debt issuance?
written by beowulf, June 23, 2010 2:34
there is no obvious reason why deficits run during a downturn need be accompanied by new debt issuance in the first place.

You mean, the US Treasury issuing money instead of debt? But that's unprecedented... since the last time it was done, I mean.

US Notes don't count against the statutory debt limit (there's still some in circulation from when Kennedy issued them) and since there's no debt service on the backend, they'd rob deficit hawk scare charts of much of their scariness.
http://www.pgpf.org/images/blog/7646586/Federal Spending as Percentage of GDP graph.jpg
written by skeptonomist, June 23, 2010 9:19
The bond markets keep beating Bernanke and other deficit alarmists over the head with their confidence in US debt: last month yields of US securities went down several tenths of a percent as the world "panicked" over Greece. But in fact there is little more that the Fed can do now with its supply-side solutions; money needs to be put in the hands of people who will use it. Money unspent does not cause inflation.
written by AndrewDover, June 23, 2010 10:01

The Fed has $1.1 trillion in Mortgage backed Securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae.

Yes, the Fed can continue to these assets. Whether they can keep housing prices at their 2003 bubble prices is yet to be seen.

(The Case-Shiller housing price index from 2003 was 130.48, and as the end of 2009 was 136.)
written by izzatzo, June 23, 2010 11:25
Apparently Leonhardt has got religion from reading Baker, who could have written the article. Reduce real interest rates even further from negative 2% to negative 5% to escape from the Keynesian liquidity trap? Take that Zero Summers.

So inflation is not the problem says Bernanke. Market confidence is the problem, in lack of expected demand.

But deficit spending which offsets lack of demand must be reduced to restore market confidence, which in turn is threatened by the Fed's heavy inventory of monetized debt which will be dumped on future markets. It's like the cartoon of Obama the Fireman on one side with a fire hose shooting stimulus water onto the fire, and on the other side with an ax trying to chop the fire hose in two.

Bernanke knows he has to play the game of the One Percent Cheney Inflation Terrorism Doctrine to keep Obama alive politically, while addressing the 99% expected deflation and the $1T+ full employment output gap with even higher deficits in the short run designed to cure market confidence, not inflation.

Once the economy recovers if ever, demand-pull inflation returns with it as a potential prospect which indeed could push up nominal interst rates and begin to compete with the Fec's ability to price its debt and sell it. Now the market confidence problem would be solved, but at the expense of real inflation risk heretofore grossly exagerrated.

What's the worst case? No one buys the Fed debt at any rate for better choices from the private sector which has now recovered, and the Fed is stuck holding it even longer, unless it chooses to crowd out the private sector with sufficiently higher rates of return. Investors won't buy it now for lack of confidence and they won't buy it then because confidence was restored, even at full employment.

And if the Fed debt causes inflation by virtue of not being exchangeable for the flood of money that exists in the economy, the Fed can suspend attempts to sell its debt and cut off what would then be demand-pull inflation with increased reserved requirements as Baker says, which is effectively a Keynesian tool to reduce excess aggregate demand, a problem the US would really like to have about now.

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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.