Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

What Assets Should the Federal Reserve Buy?

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

What Assets Should the Federal Reserve Buy?

Article excerpt

1. INTRODUCTION

For the first time in memory, large federal budget surpluses have led to a substantial paying down of federal government debt. It is even possible that most of the Treasury debt could be retired sometime before the end of the decade if the economy continues to grow steadily as it has in recent years.1

The possibility that the stock of Treasury debt could be reduced substantially in coming years presents the Federal Reserve with an important policy dilemma. The Fed implements monetary policy by buying and selling Treasury securities. Over time the Fed is a net buyer of these securities, since it must provide for the growth of the monetary base-currency and bank reservesneeded to support a growing economy. As a consequence, the Fed has acquired a portfolio of around $500 billion of marketable Treasury debt, about 15 percent of the roughly $3 trillion of marketable Treasury debt outstanding. If the stock of Treasury debt outstanding were retired, the Fed would be forced to replace its current holdings of Treasury securities with other assets. Moreover, to provide for growth of currency and bank reserves in the future, the Fed would have to acquire additional assets other than Treasury securities.2

This essay has two objectives. First, we provide a context for thinking about the broad asset acquisition policy of the Federal Reserve. Second, working within this context, we propose that the Fed and the Treasury cooperate to ensure that the Fed can continue to acquire and hold Treasury securities as fiscal surpluses reduce the stock of Treasury securities outstanding.

Fundamental principles of central banking guide our thinking. In Section 2, we distinguish between Federal Reserve monetary and credit policies. Monetary policy is concerned with the overall size of the Fed's balance sheet and involves the management of the Fed's aggregate liabilities: currency plus bank reserves. Credit policy, in contrast, involves the composition of the assets that the Fed acquires when it creates money.

From an operational perspective, the assets that the Fed buys matter little for monetary policy; asset acquisition is merely the vehicle by which the Federal Reserve injects money into the economy. Therefore, the Fed must look beyond the operational requirements of monetary policy in setting policies regarding the assets it holds. In Section 3, we argue that the Fed's asset acquisition policies should support monetary policy by protecting the Fed's independence. We assert two closely related principles. First, the Fed's asset acquisitions should respect the integrity of the fiscal policymaking process by minimizing the Fed's involvement in allocating credit across sectors of the economy. Second, assets should be chosen to minimize the risk that political entanglements might undermine the Fed's independence and the effectiveness of monetary policy.

As we explain below, the Fed's current practice of dealing in Treasury securities satisfies these two principles in a quite natural manner. As additional Treasury debt is paid down, however, the Fed can no longer count on the existence of a large outstanding stock of Treasury securities to satisfy its needs. The Fed could replace Treasury debt in its portfolio with assets such as discount window loans to depository institutions, repurchase agreements with private counterparties, securities of private businesses, debt of state, local or foreign governments, and liabilities of federal agencies or federal government sponsored enterprises, to name several possibilities.3 In Section 3 we stress that these alternatives risk drawing the Federal Reserve into potentially compromising and politically sensitive disputes involving the allocation of its credit.

We regard the design of its asset acquisition policy as part of the unfinished business of building the modern, independent Federal Reserve. The Fed's roots as a modern central bank can be traced back to the 1951 TreasuryFederal Reserve Accord. …

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