Tuesday, May 23, 2017

The Fed and the Feds

Add an “s” to a word and it becomes plural. Simple. One JD tastes good. Two JDs taste even better. There is no real confusion. The meaning of “s” is pretty clear. The same goes for the possessive “s”. That one is Larry’s JD. The “apostrophe s” is pretty clear. That is my JD and not yours.

But add an “s” to the word Fed and you get chaos. The Fed is the Federal Reserve, the central bank of the USA. The Fed is not your typical branch of government. For years, I taught that the US Fed is independent of the US government. It is not a part of the administrative, legislative, or judicial elements of the government. Ms. Yellen and the board of the Fed make important decisions about monetary policy without approval from any of those branches. It is true that the Fed itself and its administrators are created/confirmed by the government, but once in office they pretty much do what they want to do.

If you add an "s" to Fed you get the Feds. The Feds are the government, or in this discussion today, the US Treasury Department. The Treasury carries out the financial aims of the President and Congress. When government spends more than it receives in revenues, the Treasury sells government bonds or borrows from the public. That government budget deficit is what accumulates into a large national debt when the government continually spends more than it takes in. 

The confusion between the Fed and the Feds arises because they both play in a sandbox called the bond market. The Fed buys and sells already outstanding government bonds (and a few other things) as a means to carry out its monetary policy. The Feds (the Treasury) sell brand-spanking new bonds to finance the government's annual deficits. 

There was a time when the Fed was required to buy government bonds from the Feds. But in March 1951 an agreement between the Fed and the Treasury called “The Accord” let the Fed buy Hondas. Just kidding. The Accord said the Fed could no longer buy bonds from the US government. This freed the Fed from being a lap dog to the Treasury and gave it more independence to pursue its preferred monetary policies. 1951 is also known by some as the day rock 'n' roll was born. 

What a relief to not have to buy all those government bonds. Life would be easier for the government if the Fed just printed money and gave it to the government to spend willy nilly. But the Accord said no way. The government would have to find real suckers to buy all those bonds.

Are you art history majors keeping up? Great! This story has an ending. Ms. Yellen and Treasury Secretary Mnuchin run away to Ukraine together and lived happily ever after. Just fooling with you again. But there is a conclusion here about interest rates.

While the Accord agreement prevents the Fed from buying bonds from the Treasury, it does let them buy them from Pete and Charlie. You might have read that the Fed has a ton of government bonds. Experts use fancy phrases like the “Fed’s balance sheet” but those of us who got Cs in accounting know that means the Fed owns enough bonds to paper the entire Great Wall of China. They bought those bonds because the government sold them to the public and this flood of bonds caused interest rates to rise. Since the Fed hates it when interest rates rise, they bought these bonds from the market (not from the Treasury). The Fed's intent was to stabilize the government bond market and keep interest rates lower than a limbo stick at a Gary Coleman convention. 

Thus, the Fed has a lot of government bonds despite the Accord.

What the Fed does with this gargantuan pile of bonds in weeks ahead is why I wrote all that stuff above. The Fed could simply sell the bonds. Just as you advertise that you have a rusted patio chair to sell, the Fed can let the world know it wants to sell its government bonds. Since the Fed has a lot of bonds, this announcement would send bond prices plummeting and interest rates soaring. While the Fed is looking to normalize interest rates, they don’t want them soaring. So selling a bunch of their bonds too quickly is not in the cards. 

Even if the Fed sells them gradually, markets are not stupid. There are a lot of bonds.
One smart cookie noticed that many of these bonds are maturing. That is, the Fed will receive a final payment from the government and the bonds will disappear. But that is not the whole story. Where does the Treasury get the money to pay off these maturing bonds? Since the government has a whopping deficit, it can only get the money by selling even more bonds. As they do that action, interest rates would  rise and the Fed would buy more bonds from Charlie and Pete. Hmmm – an action by the Fed to reduce its bond holding causes the Fed to hold more bonds. Dern. No cigar here.

So for sure the impact of the Fed reducing its balance sheet will be upward pressure on interest rates. Whether the Fed sells its portfolio tomorrow or the next day, whether they sell the bonds or simply not renew them, the result is the same. Higher interest rates! What is the moral of the story?

A doughnut store opened across the street, and you gained 100 pounds. Despite your protestation and decision to drink one less JD per day, you are in for quite a challenge to restore normalcy.

You can swear off doughnuts but that just makes you hungrier. So long as the store is there and you don’t like hunger, you will not lose much weight.

The government has huge deficits and debt. That’s the candy store. The Fed hates 
owning all that debt but it also hates what happens when they sell it or don’t buy more of it. That's the Fed getting fat. 

The process of returning to financial normalcy starts with a government that balances its budget. It also goes with a Fed that attends to its monetary policy goals and adheres to both the wording and spirit of the Accord. The Fed is not the problem. The Feds are the problem. If government stops having large deficits then monetary policy is easier. It won't matter if the government sells short-term bonds or long term bonds. A balanced budget means they won't be selling much of either. Ms Yellen can then go fishing. 


  1. I believe I saw listing on Craig's List for some of those bonds. Janet must be getting desperate.
    So, Prof, what do the think the chances are that the Feds will do anything to reduce the deficit? That can they've been kicking is still out there in the road.

    1. I see no chance of the Feds reducing the federal government deficit. Zip. Nada.

  2. Dear LSD. I overheard Pete tell Charlie that if Trump’s domestic/econ policies gin up (er . . . JD up, whatever) GDP to 3% and create bookoos of jobs that Fed income tax revenues would provide funds to pay off those pesky bonds. This surprised Charlie lots ‘cause he never knew Pete knew diddly ‘bout econ and finance. Charlie concluded Pete got his new smarts from Trump U.

    1. Dear Tuna, I prefer not to get in between you two lovers. But I can tell you this. Even with Trump's optimistic assumptions about GDP, he doesn't balance the budget until Pete's grandchildren get out of prison. Until then the government continues to sell bonds and increase the national debt.