Monday, September 12, 2011

Federal Reserve Options and Treasury Debt Management

Last Wednesday (September 7), the Washington Post reported that one of the options the Federal Reserve was considering to bolster economic growth involved selling shorter-term Treasury securities in its portfolio and purchasing longer-term Treasuries. This is in contrast to its QE2 program, in which the Fed created bank reserves to pay for long-term Treasuries.

Last October, I wrote about the potential conflict between the Fed and the Treasury on attempts to manipulate the shape of the yield curve ("Monetary Policy and Treasury Debt Management -- A New Operation Twist?"). What I said then is relevant now. Moreover, the policy reportedly under consideration at the Fed could potentially change the maturity structure of the public debt held outside of the federal government trust funds and the Fed even more than QE2, because the new proposal entails the Fed adding to the supply of short-term debt.

During the George W. Bush Administration, the Treasury shortened the average maturity of the public debt, which culminated in a badly introduced policy of stopping the sale of 30-year bonds, which was reversed after the Treasury official responsible for this decision, Peter Fisher, left the Bush Administration. During the Obama Administration, the Treasury has been lengthening the average maturity.

For reasons that are not entirely clear, the Fed has for a long time argued that the Treasury should sell less long-term debt. For many years, the Treasury ignored this advice, but began heeding it in the Clinton Administration by reducing the amount of 30-year bonds, which used to provide the benchmark long-term interest rate to the market but has been supplanted in this role by the 10-year note. Peter Fisher of the Bush Administration came from the New York Fed and was unusually solicitous of debt management advice from the staff of the Federal Reserve Board. While Secretary Geithner was President of the New York Fed, the Treasury has reversed course on the debt maturity issue. Since Fed officials do not usually speak publicly about this type of Treasury debt management issue, there is no direct evidence about what they think of Treasury debt management policy. However, the idea of altering the maturity structure of the public debt in the market would seem to indicate that they believe that Treasury has been issuing too much long-term debt.

The Treasury, if it wanted to, could overwhelm the Fed through its enormous financing operations. One should recall in this respect that the supply of new debt is not only that due to financing the deficit but also to refinancing debt that comes due. The Treasury would be unlikely to issue more long-term debt in order to undo the Fed's policy, should it be implemented. The responsible Treasury officials would probably view the Treasury's liability portfolio to include Fed holdings, even though the interest Treasury pays on that debt is returned to the Treasury after subtracting Fed operational expenses (including the 25 basis points of interest paid on both required and excess reserves).

This highlights a gray area between the Treasury's and the Fed's responsibilities. It is not clear how much discussion between Treasury and Fed officials there has been over this issue. I would guess that there has been some and that the Treasury has indicted that it would not object if the Federal Reserve Open Market Committee decides to alter the maturity structure of the debt in the market. Given the Treasury's responsibility for debt management and its ability to work at cross purposes to the Fed through its debt management operations, I would hope that the Fed does not feel it can do whatever it wants on an issue like this without consulting the Treasury.

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