QE2 and Treasury Securities in Private Hands – Is June the End of the Fed Monetizing the Deficit?

As market participants watch the debate over increasing the debt limit proceed and consider how to adjust their trading strategies for the upcoming end of the Federal Reserve's second quantitative easing program ("QE2") in June, I thought it would be interesting to look at Treasury debt held in private hands since November 2010, when QE2 started. The numbers indicate that federal debt held in private hands decreased during the period in spite of the large budget deficit which is being financed.

On November 3, 2010, federal debt held by the "public," which excludes government trust fund holdings but includes Federal Reserve holdings, stood at $9,134 billion, according to the "Daily Treasury Statement." On that day, the Federal Reserve reports holding $842 billion of Treasury securities outright, according to Federal Reserve Statistical Release H.4.1. On May 4, 2011, the comparable numbers were $9,698 billion and $1,442 billion. In other words, ignoring some possible accounting and definitional differences between Treasury and Federal Reserve statistics, the federal debt in private hands decreased from $8,292 billion to $8,256 billion from November 3 to May 4.

It should be noted, however, that the decrease in private holdings of federal debt is more than accounted for by Treasury's reduction of outstanding Treasury bills issued in connection with the Supplementary Finance Program (a program I have discussed and criticized in previous posts – here, here, and here.) On November 3, Treasury had $199.6 billion of bills outstanding to finance this account; this had declined to $5 billion on May 4. (The Treasury has let the bills run off for this program because of the debt limit impasse.)

The Supplementary Finance Program, which assists the Federal Reserve in draining reserves from the banking system, is in essence Treasury borrowing of cash it does not need. If the Fed is targeting overall bank reserves, then the Fed would have had to counteract the increase in bank reserves due to the decrease in cash in the Supplementary Financing Program account by selling Treasury securities or other securities into the market. I do not know how the Federal Reserve adjusted its open market operations in reaction to the reduction in the Supplementary Financing Program account.

If, come June, the Fed begins maintaining the size of its balance sheet but does not increase it, there will be an increased supply of Treasury securities that the market will have to digest. Also, if, after the debt limit is increased, Treasury decides (probably in consultation with the Fed) to increase the amount in the Supplementary Financing Account to perhaps around $200 billion, this will further increase the amount of Treasury securities in the market.

One assumes that the Fed is considering how the market will react to the supply effects as it decides what to do next. Treasury has no choice but to continue to issue securities, whether the Fed helps by buying in the secondary market or not.

(Note: the figures for federal debt include non-marketable Treasury securities such as U.S. Savings bonds and State and Local Government Series Securities, which state and local governments invest in for tax reasons.)