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11 23 2015 | by Victor Xing | Central Banks

Why won’t the Federal Reserve support debt monetization?

Some would prefer the idea of monetizing U.S. debt obligation and use the Federal Reserve as a funding mechanism (the FED was used exactly for this purpose in the past, but more on this in a bit), but under today’s environment, debt monetization will be extremely difficult to accomplish for as long as the Federal Reserve remains an independent central bank.  History also outlined severe consequences from Weimar Republic‘s desperate attempt to monetize war reparations.

Federal Reserves’ resistance toward debt monetization are several-fold and rooted in historic context

  1. Federal Reserve is an independent central bank (please see monetary policy autonomy), and its conduct of monetary policies are outside of political interference (to many politicians’ dismay).

    However, it is important to emphasize that the Federal Reserve had to fight for its policy independence.  Between 1942 and 1951, the FED had indeed kept rates low at the request of the Treasury Department to help monetize the nation’s debt.  The Federal Reserve eventually fought for its policy independence, which resulted in the 1951 Accord:

    Federal Reserve Bank of Richmond – The Treasury-Federal Reserve Accord

    The Federal Reserve System formally committed to maintaining a low interest rate peg on government bonds in 1942 after the United States entered World War II. It did so at the request of the Treasury to allow the federal government to engage in cheaper debt financing of the war. To maintain the pegged rate, the Fed was forced to give up control of the size of its portfolio as well as the money stock. Conflict between the Treasury and the Fed came to the fore when the Treasury directed the central bank to maintain the peg after the start of the Korean War in 1950.

    President Harry Truman and Secretary of the Treasury John Snyder were both strong supporters of the low interest rate peg. The President felt that it was his duty to protect patriotic citizens by not lowering the value of the bonds that they had purchased during the war. Because bond prices vary inversely with bond interest rates, a rise in interest rates would have made the same bonds purchased at the lower interest rates worth less on the government securities market. Unlike Truman and Snyder, the Federal Reserve was focused on the need to contain inflationary pressures in the economy caused by the intensification of the Korean War. Many on the Board of Governors, including Marriner Eccles, understood that the forced obligation to maintain the low peg on interest rates produced an excessive monetary expansion that caused the inflation. A fierce debate between the Fed and the Treasury then ensued as both vied for control over interest rates and U.S. monetary policy.

    This website tells the story of how the Federal Reserve and the Department of the Treasury settled their dispute. The resulting agreement, known as the Treasury-Fed Accord, eliminated the obligation of the Fed to monetize the debt of the Treasury at a fixed rate. This agreement became essential to the independence of central banking and laid the foundations for the monetary policy pursued by the Federal Reserve today.

  2. Funding fiscal expenditure is not part of the Federal Reserve’s Congressional mandated objectives (in-fact, debt monetization would be one of the major risks of the price stability objective)
  3. Federal Reserve’s balance sheet expansion programs (or “money printing programs”) were designed with the following economic objectives in mind
    • Ease credit lending conditions “with the aim of providing support to the mortgage and housing markets” via purchases of MBS and Fannie, Freddie (GSE) debt
    • Use large scale asset purchases to push out investors’ expectation of future rate hike
    • Induce financial sector risk-taking to ease financial condition (pushing down long-term borrowing cost and drive up asset prices).
    • The increase in money supply was initially treated as a by-product of credit easing (FED Chair Bernanke questioned the efficacy of quantitative easing in 2008 before it too was adopted in QE2)

In conclusion – after being used as a “piggy bank” for the Treasury Department between 1942 and 1951, the Federal Reserve will fight tooth and nail to maintain its policy independence (which is now threatened by the “audit the FED” movement) and resist against the call for debt monetization.

debt monetization is not a policy objective
Monetizing public debt was not (and will not be) part of the QE objective.

Next article11 23 2015 | by Victor Xing | Capital Markets

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