What Should the Federal Reserve Do as Treasury Debt Is Repaid?
- What Should the Federal Reserve Do as Treasury Debt Is Repaid?
The search for answers to the question of how the Federal Reserve should modify its techniques for providing reserves as Treasury debt is repaid has receded somewhat in urgency in recent months. Owing to economic weakness and fiscal policy actions, the surpluses that had marked actual and projected unified budgets of late have turned into deficits. But the issue probably has not gone away entirely. Reasonably robust growth of potential output and a modicum of fiscal discipline would tend to cause such surpluses to reemerge before very long. In that circumstance, the Federal Reserve might not have a lot of breathing room to decide how to adapt. Given the tendency for Treasury securities to be locked up in portfolios, even the short-lived surpluses in recent years significantly reduced the liquidity of the Treasury securities market and affected the conduct of open market operations in such securities. The System has had to impose per-issue limits on its holdings of Treasury securities, rely more on long-term repurchase agreements to supply reserves, and broaden the range of collateral it accepts on those RPs.
Considering alternatives to Treasury securities for the Federal Reserve is also an interesting intellectual challenge. It involves thinking about the price discovery process in financial markets, the public good aspect of the Treasury debt—its use as a benchmark and in risk management—and the interaction of those attributes with Federal Reserve behavior. For example, to preserve the value of any public good as long as possible, the Federal Reserve might want to reduce its holdings of Treasury debt more quickly than the Treasury pays it down. And it raises issues about the nature of the central bank and the interaction of its balance sheet adjustments with credit and resource allocation and with the political process. [End Page 941]
The Treasury Market
The Treasury market has been the ideal venue for Federal Reserve asset operations. This has been especially true since the mid-1970s. Prior to that, open market operations often were affected by the need to keep the markets stable during Treasury financings—so-called "even keel" periods. Since then, the liquidity of this market, enhanced by regular auctions and the development of the primary dealer system, has become deep enough that the central bank no longer had to be concerned about the interaction of its operations with Treasury debt sales and debt management.
When the Federal Reserve purchases Treasury debt it is not engaging in credit intermediation or transformation. It issues government obligations—currency and reserves— and holds government obligations as assets. It does not change the government debt (broadly defined) in the hands of the public, it is not forced to choose among private borrowers, and it does not place taxpayer resources at risk. Moreover, because the Treasury market has been highly liquid, the Federal Reserve can make large changes in its portfolio without affecting prices, though, as noted, that liquidity is already eroding a bit. Such changes might be needed to counter normal short-run variations in its balance sheet, such as the seasonal movements in reserves, currency, and Treasury deposits, or they might arise from unusual developments like large discount window loans or purchases of foreign exchange that needed to be sterilized to keep money market conditions unchanged. The Federal Reserve has maintained the liquidity of its portfolio—and in particular its ability to shrink its assets—by holding a large quantity of Treasury bills and of RPs of various maturities, both of which can be allowed to run off and would not need to be sold outright in what might be illiquid market conditions.
Alternative Assets
No substitutes for Federal Reserve holdings of Treasury debt do as good a job at attaining simultaneously the portfolio objectives of liquidity, safety, and neutrality in private credit allocation. Every alternative entails some trade-offs among these objectives. In particular, choices that promise to maintain the liquidity and safety of the portfolio tend to clash with desires to avoid influencing the allocation of credit among private borrowers.
Some possible alternatives tend to emphasize maintaining liquidity and safety. These options would...
