Monday, November 15, 2010

Is the U.S. Treasury in Control of Debt Management?

Early on in my career in the Domestic Finance section of Treasury, my then boss, a career civil servant who even by that time had been at Treasury for a long time, told me that it was the Fed’s policy to keep the maturity structure of its permanent portfolio similar to what the Treasury had issued, so as not to impact debt management. I did not run the numbers at that time to check if what my boss had told me was correct, but it is clear that this is not current Fed policy.

The Treasury is of course aware of this but seems to want to minimize the issue. In the November 3 quarterly refunding press conference, Assistant Secretary for Financial Markets Mary J. Miller made a point of saying that Treasury decisions with respect to debt issuance are made independently of the Fed and even quoted a Treasury Borrowing Advisory Committee (“TBAC”) member as saying that the Fed should be just considered as a big investor.

I am more inclined to agree with the sentiment of the TBAC member, who, according to the minutes, said that “the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.”

Of course, that is not quite right. Not only is the Fed reducing the amount of Treasury notes available to the market, it is reducing the total amount of debt securities needed to be in the market in order to keep the government financed. As for bills, their relative importance to debt management is increased, but not necessarily their quantity.

With respect to T-bills, though, I note that the Treasury continues to have issued bills it does not need to keep the government financed in an amount of nearly $200 billion. The proceeds of these bills are deposited in the Supplementary Financing Program Account. Treasury’s issuance of bills to borrow money it does not need and depositing it at the Fed serves to drain banking system of reserves. Why Treasury is still doing this when the Fed has an announced policy of increasing reserves is not clear, but I am sure that, even with all the talk of Treasury independence from the Fed, the Treasury and the Fed from time to time discuss this program. (It is noteworthy that Treasury is emphasizing its independence from monetary decisions, not the Fed insisting on its independence from Administration policy.) One can be sure, though, that when the Treasury bumps up against the debt limit next year and the likely debt limit theater again puts on one of its periodic performances in Washington, the Supplementary Financing Program Account will be tapped. (Previous comments of mine on the Supplementary Financing Program Account and Treasury cash can be found here and here.)

I am not going to assess the wisdom of the Fed’s new policy here. What I would like to note, though, is that, while the Fed is not permitted by statute to lend to the Treasury, it is effectively monetizing the deficit by buying record amounts of Treasury securities in the secondary market. While the Federal Reserve Banks are technically private institutions, there is no way other than to view them as part of the government for policy analysis. They are not just another investor, albeit large. The interest the Treasury pays on the securities the Fed owns comes back to Treasury in the form of “interest on Federal Reserve notes.” The Fed subtracts its expenses from the amount it remits to the Treasury. This used to mean that Treasury got virtually all the interest it paid on securities newly acquired by the Fed, since the Fed’s increasing its balance sheet did not affect its expenses. Now it does, since the Fed pays 25 basis points on bank reserves, but there will still be funds remitted to the Treasury from the notes the Fed acquires under the new program.   

Of course, at some point, the Fed will want to drain bank reserves from the banking system. It is unclear when that will happen, but, when it does, Fed sales of Treasury notes will compete with the Treasury’s own sales. 

While it is true that the Treasury, not the Fed, makes the final decisions about what the Treasury will auction, it is silly to claim that the Fed is just another investor and to give the impression that Treasury debt management is not impacted by Fed actions of the current magnitude. Much of the audience for the quarterly refunding press conferences knows this; what is the point of pretending otherwise?    

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