Monday, July 26, 2010

The Opposite of Monetization

One objection to the Fed’s erstwhile policy of purchasing longer maturity Treasury securities was that the Fed was “monetizing the debt.” I find this objection odd. The Fed had set a near-zero target for the federal funds rate, and it was already committed, if necessary, to maintain this target by purchasing an indefinite quantity of Treasury bills. In practice it hasn’t had to do many such purchases, because there are plenty of private sector buyers willing to “monetize the debt” on their own, and when the Fed purchases other assets, the sellers of those assets go ahead and buy T-bills with the proceeds. But generally, open market operations – consisting primarily of purchases and sales of T-bills – are the normal method by which the Fed enforces its interest rate policy, and accordingly, “monetization” of some sort is inherent in the zero interest rate policy that was already in place when the Fed began its longer-maturity Treasury purchases (and that remains in place today).

It will be objected that T-bill purchases – even if they were actually happening – are temporary. T-bills mature quickly, and if the Fed buys T-bills today, it is not obliging itself to roll over those purchases when the bills mature. Thus it is only temporarily monetizing the debt, for such a short period of time that it hardly matters. By contrast, when the Fed purchases longer maturity Treasuries, it is paying for government expenditures without requiring to Treasury to repay any time soon.

But this view is deceptive. Assuming that the Fed maintains its resolve to prevent the inflation rate from rising significantly above 2%, and assuming that the economy does recover before the aforementioned securities mature (because otherwise the question is moot anyhow), the Treasury will have to repay the money. How will it have to repay the money, if the securities are still outstanding? Since the Fed’s profits go into the Treasury, any reduction in the Fed’s profits is equivalent to a payment by the Treasury. And if the economy does recover, the Fed will, to prevent that recovery from overheating, either raise the interest rate it pays on excess reserves or liquidate the Treasury securities at a loss. Either way, its profits go down, and the Treasury loses, just as if the Treasury had had to repay the money directly.

The real issue is whether the Fed will be tempted to abandon its inflation target. So let’s imagine the Fed, say, 5 years from now, under two different scenarios where the Fed faces a dramatic increase in the velocity of money and has to choose whether to allow inflation. In the first scenario, the Fed’s portfolio is full of long-term Treasury bonds. In the second, it’s full of short-term bills. Under which scenario will the Fed be tempted to allow inflation?

Under the first scenario, the Fed would have to choose whether to liquidate its Treasury bonds at a loss. If the Fed were simple-minded, it would be tempted to avoid the loss by holding on to the bonds and allowing the economy to overheat. But the Fed isn’t so simple-minded: Fed officials will be well aware of the effect that inflation would have on the value of their bond portfolio. If they don’t liquidate, they will face the same decision a year later under worse conditions. And if they don’t liquidate then, they will face the same decision a year after that under yet worse conditions. In all likelihood, they will follow the logic through to its conclusion and realize that they have little choice: holding the bonds to maturity is not really an option (unless they want to risk hyperinflation, which we can presume they won’t), and the best alternative is to liquidate the bonds before inflation becomes an issue, because waiting would only increase their losses. So a Fed with a portfolio of long-term bonds is not one that is likely to tolerate inflation.

Now look at the other scenario. With a portfolio of short-term Treasury bills, the Fed faces the decision whether to allow the economy to overheat and produce inflation. There are no losses to worry about, so you might think the decision would be easy: just sell some of the T-bills, contract the money supply, and avoid inflation. But there’s another consideration. If the Fed didn’t buy bonds in the first place, then those bonds remained in the hands of the public. This means the government will have to repay those bonds, which means that it may have to raise taxes or cut public services. Inflation is one form of tax, and when the public debt is large, inflation is a tax that can generate considerable revenue while arguably producing only a minimal amount of distortion in the economy. With no losses of its own to worry about, the Fed may quite rationally decide that an inflation tax is better than the alternatives. So, if anything, the temptation to allow inflation is higher when the Fed’s portfolio doesn’t include long-term bonds.

In terms of its likely implications for future inflation, buying longer-term Treasury securities is not monetization; it is the very opposite of monetization. This conclusion is actually a little bit disturbing, because it means that asset purchases by the Fed may have just the wrong effect on the real interest rate. Rational markets will anticipate less, not more, inflation when the Fed purchases long-term bonds, and this will only serve to make real investment less attractive – just the opposite of the intended effect. On the other hand, Fed bond purchases would have a direct effect on the real interest rate by reducing the available supply of bonds, and my guess is that this effect would outweigh any adverse effect via inflation expectations.

In any case, the implications for bond investors are unambiguous: Fed asset purchases are good for you. Some caveats are needed, though. The likelihood of additional asset purchases (if you believe there is such a likelihood) does not necessarily imply a buying opportunity, since the rest of the market may also be anticipating it. And one has to take into account a couple of important risks. The Fed could come to its senses and announce higher inflation targets, which would clearly be bad for bond investors (at least at a certain horizon, though the dynamics could be complicated). And Fed asset purchases (indeed, even those that have already taken place) may end up having the intended effect by getting a more solid recovery going. The big risk is that things will go back to normal.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


Adam P said...

Andy, this is a really, really good point.

But nonetheless, wasn't the whole point of intoducing interest on reserves that the fed could tighten without selling any of the securities it holds? Especially since the mortgage bonds might well end up worthless.

The fed can always just raise the rate it pays on reserves, it won't need to sell anything.

Andy Harless said...

Adam, my argument is that raising the interest rate on excess reserves is more or less equivalent to selling bonds at a loss. Either you take the loss as a capital loss on the bonds, or you take the loss as an expense over time by paying more interest. In contrast, if you have a portfolio of short-term securities, you can drain reserves by selling them without taking a loss, and then there are fewer reserves on which to pay interest. (And since interest is only on excess reserves, you can presumably get down to where little in interest payments are required). Interest on reserves is a convenience, because you can raise it without disrupting markets, but it doesn't allow the central bank to avoid losses that would otherwise be necessary.

Another way to make my main argument is to think of the government and central bank as a unit. When the CB buys long-term bonds, it's as if the government were not issuing them in the first place: the govt+CB is net short-term financed. If the CB doesn't buy bonds, but the government still issues them, then the govt+CB is net long-term financed (at least relatively speaking). So which government would you trust more not to inflate, the one that's short-term financed or the one that's long-term financed?

There's also seignorage revenue, but in the long run the total seignorage is dictated by the inflation policy. So beyond a certain point, anything that looks like seignorage in the short run is really just short-term financing. (Imagine if the CB just credited the Treasury's account and wrote that off immediately as a loss. That would look like pure seignorage, but when the economy recovers, the CB would have to undo that seignorage by paying interest on reserves that it would be unable to drain.)

Tschäff said...

How do you know the fed hasn't been purchasing tsy secs i.e. monetizing the debt?

Secondly, you assume that the fed can fight inflation by raising the interest rate either by higher interest on reserves or via open market operations. This is something I'm not convinced the fed has much control over. I have a growing suspicion that zero interest rates are deflationary / higher interest rates are inflationary. Yes, higher interest rates do decrease the amount of bank loans being made, at least when the economy isn't in the ponzi phase, but it also makes debt servicing more expensive pushing up the costs of business for those who borrow, i.e. businesses & governments. (cost-push inflation), and for another reason I'll get back to at the end.

Really using taxes to decrease aggregate demand (thus inflation) is the tool for the job. Not only is it a sharper tool (can target only overheating sectors), but more fair too (progressive).

If non-gov financial wealth is held in the form of tsy secs or bank reserves the main difference is one pays interest and the other doen't (or didn't till recently). So actually it would be LESS inflationary if the government would spend without issuing a tsy secs, I.E. monitize the debt. See more here

Scott Sumner said...

Andy, I hadn't given this issue much thought, but it does seem to me that you are right. I've always thought that expectations of inflation in the US are not so much based on fiscal considerations, as expectations of future monetary policy intentions. Thus buying long term bonds is only inflationary if the market takes it as a signal that the Fed is getting serious about boosting inflation over time. This might or might not be the case; I don't have strong views either way.

Anonymous said...

Fundamentals and expected house prices to keep rising simply because they were already rising.