Monetizing the Debt
Axel Merk
Merk Hard Currency Fund
Dec 2, 2008

Deflation won't happen here; at least not if Federal Reserve (Fed) Chairman's Ben Bernanke's plan pans out. Deflation is considered a persistent decline in prices of goods and services; in a speech in 2002, Bernanke outlined the steps he would take if the U.S. ever faced the threat of deflation. Deflation is suffocating anyone holding debt as the debt burden becomes more difficult to finance with shrinking income; in contrast, inflation bails out those who have a lot of debt. In our assessment, fighting deflation is the Fed's top priority now; the latest minutes from the Fed's Open Market Committee (FOMC) meeting state: Indeed, some [FOMC members] saw a risk that over time inflation could fall below levels consistent with the Federal Reserve's dual objectives of price stability and maximum employment. [..] the limited scope for reducing the [Federal Funds] target further were reasons for a more aggressive policy adjustment; [..] more aggressive easing should reduce the odds of a deflationary outcome.

To understand how "more aggressive" easing is possible when interest rates are close to zero, a little background is required on how the Fed is "printing" money. Until a few weeks ago, the Fed's main tool to control interest rates was to manage the Federal Funds target rate by engaging in "open market operations" to buy or sell short-term government securities, mostly Treasury Bills. These operations are based on the principle that banks have cash deposits as reserves to lend money; for any dollar on deposit, a multiple may be provided as loans; the basic principal of modern banking assumes that not all depositors will want their money back simultaneously; a 'run on the bank' would occur in such a situation that would either result in the Fed coming to the rescue or the bank's failure.

The Fed can now "tighten" monetary policy by selling, say, Treasury Bills, to the bank; in return, the Fed will receive the cash; and the bank will have less cash available to lend - because of the multiplier effect, small actions by the Fed tend to have - albeit with a delay of a couple of months - significant impact on lending and thus economic activity. There are no coins exchanging hands; these are entries into the balance sheets at the bank and the Fed. By making cash less available in the banking system, the cost of borrowing, i.e. interest rates, goes up.

Conversely, the Fed can buy Treasury Bills from banks and supply them with cash (providing liquidity) in return. This unleashes lending power at the banks and lowering the cost of borrowing.

This world was shaken when Congress, as part of passing the TARP bank bailout program, authorized the Fed to pay interest on deposits at the Federal Reserve. Theoretically, even if the Fed provides massive amounts of liquidity, interest rates should not go to zero as banks should always be able to go to the Fed and receive interest on deposits there. The idea is that the banking system could be flooded with liquidity while ensuring that interest rates don't go down to zero. Fed officials are fairly miffed that the market hasn't quite worked that way as short term Treasury bills have hovered close to zero with the official target Federal Funds rate at 1% and the interest paid on deposits at the Fed at or near 1%. Note that many of the new programs the Fed has introduced have little or no historic precedent; as a result, the programs may not be as effective or may have unintended consequences.

Aside from paying interest on deposits, the Fed, using the above model, can do a lot more to provide "liquidity". Namely, the Fed is not limited to buying and selling T-Bills; as recent announcements have shown, the Fed is free to buy just about anything: mortgage backed securities (MBS), car loans, commercial paper, to name a few; the Fed could also buy typewriters, cars, domestic or international stocks, anything. In an announcement on November 25, 2008, the Fed said it would buy up to $600 billion of mortgage-backed securities issued by the government-sponsored entities (GSEs) Fannie and Freddie.

For example, a bank would like some cash, but cannot find a buyer for mortgage-backed securities it holds. The Fed may step in, buy the securities and provide the bank with cash. The bank in turn is now free to lend money - a multiple of the cash received.

How does the Fed get its money? It doesn't need to borrow it; it merely creates an entry into its balance sheet. All the Fed requires to "print" money is a keyboard connected to a computer. The difference between the Fed and the Treasury issuing money is that the Treasury needs to get permission from Congress before selling bonds. In this context, it shall be mentioned that physical cash (coins, bank notes) are entered as liabilities on the Fed's balance sheets; they are rather unique liabilities, however, as you can never redeem your cash: if you went to a bank, the best you can hope for in return for your dollar bill is a piece of paper that states that the bank owes you one dollar. While it is possible for central banks to remove cash in circulation, they are not obliged to do so.

Until recently, the Fed would only temporarily park non-government securities on its balance sheet: a bank would typically receive a temporary, often overnight, loan for depositing top rated securities with the Fed; these "swap agreements" were traditionally intended for very short-term loans, but the crisis has led the Fed and other central banks around the world to engage in 60, 90 day or even longer agreements. Since late September, the idea of swap agreements has been supplemented by outright purchases.

When the Fed issues cash for debt securities it acquires, we talk about "monetizing the debt".

This can be taken a step further, although this last phase has not yet been implemented: when the government needs to raise money, the Treasury issues debt in form of Treasury bills and Treasury bonds. To keep the cost of borrowing for the government low, the Fed may step in and buy Treasury bonds. Whereas traditionally, the Fed is actively managing short-term interest rates by buying and selling short-term Treasury bills, the Fed may also buy, say, 10 or 30-year bonds. It's a wonderful funding mechanism: if the Treasury needs to raise cash, the Fed could come and provide it.

Isn't this extremely inflationary? Quite possibly, quite likely, but not necessarily is the short answer. First of all, the Fed has the ability to "sterilize" its debt monetization program. Take the situation where the Federal Reserve buys "highly rated", toxic assets from the bank, but doesn't want the bank to go out and lend a multiple of the cash it receives. What the Fed can do is to sell the same bank, for example, some Treasury bills to "mop up" the extra liquidity. This would have the impact of improving the bank's balance sheet without supercharging the economy. Indeed, in late September the Treasury instructed the Fed to do just that; they even invented "Supplementary Financing Program" (SFP) bills for this purpose. On the chart below, the dark blue line indicates the cumulative growth in the Fed's balance sheet, i.e. the Fed's "printing of money"; the light blue line shows the cumulative activity to mop up the added liquidity by selling SFP bills to banks. The Fed's balance sheet has grown by about $1.2 trillion to currently over $2 trillion; Dallas Fed President Richard W. Fisher said the Fed's balance sheet may reach $3 trillion by January.