This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
This essay addresses an issue that I purposely ignored in my previous two essays on the national debt problem. Specifically, the Fed’s contribution to the U.S. debt problem and the potential danger it creates.
In order to understand the Fed’s role, you must know two facts.
First, the Fed is considered part of the “public” in the Treasury’s measure of the public debt. This means when the Fed purchases the marketable debt the Treasury issues, the rest of the “public” doesn’t have to buy it.
The second fact is the Fed returns all of its income net of its operating expenses to the Treasury. This means that the Treasury is almost getting an interest-free loan from the Fed. Indeed, since the Bernanke Fed decided to implement its so-called large-scale-asset-purchase program, better known as quantitative easing (QE), the Fed has purchased a large amount of mortgage-backed securities and agency debt.
Consequently, the Fed has been returning more interest income to the Treasury than the Treasury paid to the Fed.
The Fed has passed $858.9 billion to the Treasury from 2009 through 2019. Had the Fed not had a large balance sheet, the public debt would be nearly $1 trillion higher—$20.86 trillion rather than $20 trillion on June 3, 2020.
As of June 3, 2020, the Fed was holding $4.1 trillion of Treasury securities, 20.6% of the public debt. For a point of comparison on March 11, 2009—one week before the Bernanke Fed began QE, the Fed held $474.6 billion of Treasuries, or 7.1% of the public debt, which was just $6.7 trillion on this date.
If the Fed had just maintained its relative holding of Treasury debt, it would be currently holding about $1.4 trillion of Treasury securities. Hence, the market would have had to finance an additional $2.7 trillion of marketable government debt.
The Fed’s bloated balance sheet will be problematic if inflation begins to accelerate for two reasons. First, and most likely foremost, the Fed would have to sell a lot of securities if it wants to reduce the money supply. As long as banks are holding more excess reserves than they want to hold (see Federal Reserve Mischief and the Credit Trap, p. 278, to see why banks are essentially being forced to hold excess reserves), banks will continue to make loans out of excess reserves and the money supply will continue to increase.
The only way the Fed can stop the money supply from increasing is to reduce excess reserves to the point where banks have to finance their lending in the public credit market as they did prior to QE. To reduce the money supply, the Fed would actually have to reduce the total supply of reserves, something it has seldom done without a large reduction in reserve requirements.
Conclusion: Reducing the money supply will be extremely difficult.
The second problem is not likely to happen. If the inflation rate begins to increase, interest rates will rise and the market value of the Fed’s security holdings will decline.
If inflation caused interest rates to increase a lot and fast enough, it is possible that the value of the Fed’s portfolio would shrink to the point where it would be unable to reduce excess reserves to the point necessary to prevent further increases in the money supply. I doubt this will happen.
The Fed will likely sell its longer-term securities and purchase shorter-term securities if interest rates increased sufficiently. But it could happen to a degree that would make the Fed very uncomfortable.
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.