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43 2 DEBT MANAGEMENT CONFLICTS BETWEEN THE U.S. TREASURY AND THE FEDERAL RESERVE Robin Greenwood, Samuel G. Hanson, Joshua S. Rudolph, and Lawrence H. Summers In this chapter, we discuss conflicts between the U.S. Treasury and the Federal Reserve in their debt management operations. Our use of the term “debt management operations” is not a conventional way to describe Federal Reserve policy, but we use it here to recognize the role that the Fed has in influencing the net supply of debt held by the public. We start by documenting empirically the extent to which monetary and fiscal policies have been pushing in opposite directions in recent years. We show that, despite successive rounds of quantitative easing (QE), the stock of government debt with a maturity over five years that is held by the public (excluding the Fed’s holdings) has risen from 8 percent of GDP at the end of 2007 to 15 percent at the middle of 2014. Pressure on bond investors to absorb long-term government debt has actually increased rather than decreased over the last six years! We find that between two-thirds and three-quarters of the increased supply of longer-term Treasuries is explained by the dramatic growth in outstanding debt due to the large deficits associated with the Great Recession. 44 R. Greenwood, S. G. Hanson, J. S. Rudolph, and L. H. Summers The remaining one-quarter to one-third is due to the Treasury’s active policy of extending the average maturity of its debt. In discussions of its QE policies, the Federal Reserve has focused on the effects that its bond purchases were expected to have on long-term interest rates and, by extension, the economy more broadly. However, in doing so, it completely ignored any possible impact on government fiscal risk, even though the Federal Reserve’s profits and losses are remitted to the Treasury. Treasury’s debt management announcements and the advice of the Treasury Borrowing Advisory Committee (TBAC), a committee of investment managers and bankers who meet regularly to advise the Treasury debt managers , have focused on the assumed benefits of extending the average debt maturity from a fiscal risk perspective and largely ignored the impact of policy changes on long-term yields. To the extent that the Federal Reserve and Treasury ever publicly mention the other’s mandate, it is usually in the context of avoiding the perception that one institution might be helping the other achieve an objective. The Fed does not want to be seen as monetizing deficits. The Treasury has been reluctant to acknowledge the role that the Fed has in debt management—the Treasury effectively treats the Fed as nothing more than a large investor. We then place the current tension between Federal Reserve–led debt management and Treasury-led debt management in historical perspective. Before 2008, changes in Federal Reserve holdings of long-term bonds had only a tiny impact on the amount of long-term Treasury debt held by the public—that is, Fed policy had little direct impact on the consolidated debt management strategy of the U.S. government. However, we describe a few historical examples in which the Federal Reserve and the Treasury agreed to coordinate policy for the purpose of achieving a common set of objectives with regard to debt management. Thus, history suggests that greater cooperation on debt management is possible. We argue that improved cooperation between the Treasury and the Federal Reserve in setting debt management policy would be in the national interest. We outline the principles that would form the basis for such cooperation . In sketching this framework, we draw on the arguments we developed in chapter 1, where we laid out a trade-off model for the management of the consolidated government debt. According to this model, optimal debt maturity trades off objectives of financing the government at the lowest cost and at a suitable level of refinancing risk (typically considerations taken up by the Treasury) with considerations related to financial stability and aggre- gate demand management (typically considerations taken up by the central bank). Given these objectives, it is straightforward to describe settings in which, under current institutional arrangements, the Treasury may come into conflict with the Federal Reserve because it places different weights on the competing objectives of debt management. While the potential for conflict is greatest when interest rates are at the zero lower bound, we suggest that a lack of coordination can lead to suboptimal policy during ordinary...


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