Tuesday, October 12, 2010

Monetary Policy and Treasury Debt Management -- A New Operation Twist?

In reaction to economic weakness and little likelihood in the near-term of any significant fiscal stimulus, the Federal Reserve seems ready to buy a significant amount of longer-term Treasury securities. This has been popularly called "QE2" -- a second round of quantitative easing -- with some no doubt enjoying that this name sounds more like a luxury ocean liner than a policy.

In a speech at a conference sponsored by Deutsche Bank this weekend in Washington, DC coinciding with the World Bank/IMF annual meetings, former Fed governor Laurence Myer said that calling the likely new policy quantitative easing was somewhat misleading -- reserve creation (increase in Fed liabilities) is just a by-product of the Fed increasing the asset side of its balance sheet. I think his point is that, since banks are sitting on a significant amount of excess reserves, the reserve creation is secondary to the effort to decrease longer-term Treasury yields.

Another former Federal Reserve governor (and vice chairman), Alan Blinder, in an appearance on Sunday at the annual meeting of the Institute of International Finance in Washington said that there might be tension between debt management and a Fed policy of buying longer-term Treasury securities.

Indeed there might. Mr. Blinder indicated that if he were in Secretary Geithner's shoes, he might want to issue more long-term Treasury securities in light of low interest rates and that this could result in a "Mexican standoff" between the Fed and the Treasury. In fact, as I discussed in a previous post, the Treasury has already reversed the shortening strategy of both the Clinton and George W. Bush Administrations and is lengthening the average maturity of the public debt.

We have seen this before. In the early 1960s, the Treasury and the Fed embarked on "Operation Twist."  The desire was to increase short-term interest rates to protect the dollar in the foreign exchange markets and to lower long-term interest rates in order to promote economic growth. The idea was that both Fed open market operations and Treasury debt management would be conducted to increase the supply of T-bills in the market and reduce the amount of longer-term debt. The result of this exercise was, at best, inconclusive. There is some question how hard Treasury tried to play its part, since the average maturity of the public debt after briefly declining started increasing.

At some point under the likely new Fed initiative, Treasury may think it is losing control of debt management policy, especially if the Fed purchases in the neighborhood of a trillion dollars of Treasury notes and bonds.  While the Treasury will control what it issues to finance the government, it will be ceding to the Fed the authority to determine the quantity of long-term debt in private hands unless it tries to undo the Fed's policy.  (For this purpose, though the Federal Reserve banks are technically private, they are really part of the government, and the interest they earn on Treasury securities above the amount the Federal Reserve System needs for expenses -- including paying interest on reserves -- is remitted to Treasury.) Also, when the Fed at some future date decides the time has come to shrink its balance sheet, the sale of Treasury securities will complicate Treasury's debt management.

The Fed, while not shy about giving the rest of the government advice, resists any statements or advice from the Administration on monetary policy. In this case, though, one hopes that there is close consultation between the Fed and the Treasury since a core function of Treasury is impacted. The Mexican standoff that Blinder worries about should be avoided.

Finally, whether or not the new Fed policy will work, even if the Treasury cooperates, is  an open question.

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