Treasury – Donald Marron

The Federal Reserve is Not Ending Its Stimulus

Yesterday, the Federal Reserve confirmed that it would end new purchases of Treasury bonds and mortgage-backed securities (MBS)—what’s known as quantitative easing—in October. In response, the media are heralding the end of the Fed’s stimulus:

“Fed Stimulus is Really Going to End and Nobody Cares,” says the Wall Street Journal.

“Federal Reserve Plans to End Stimulus in October,” reports the BBC.

This is utterly wrong.

What the Fed is about to do is stop increasing the amount of stimulus it provides. For the mathematically inclined, it’s the first derivative of stimulus that is going to zero, not stimulus itself. For the analogy-inclined, it’s as though the Fed had announced (in more normal times) that it would stop cutting interest rates. New stimulus is ending, not the stimulus that’s already in place.

The Federal Reserve has piled up more than $4 trillion in long-term Treasuries and MBS, thus forcing investors to move into other assets. There’s great debate about how much stimulus that provides. But whatever it is, it will persist after the Fed stops adding to its holdings.

P.S. I have just espoused what is known as the “stock” view of quantitative easing, i.e., that it’s the stock of assets owned by the Fed that matters. A competing “flow” view holds that it’s the pace of purchases that matters. If there’s any good evidence for the “flow” view, I’d love to see it. It may be that both matter. In that case, my point still stands: the Fed will still be providing stimulus through the stock effect.

P.P.S. I wrote about this last year during the tapering debate. In the lingo of that post, the Fed is moving from quantitative easing to quantitative accommodation. To actually eliminate the stimulus, the Fed would have to move on to quantitative tightening.

The Fed and America’s Debt

Is the Federal Reserve part of the government? You might think so, but you wouldn’t know it from the way we talk about America’s debt. When it comes to the debt held by the public, for example, the Fed is just a member of the public.

That accounting reflects the Fed’s unusual independence from the rest of government. The Fed remits its profits to the U.S. Treasury each year, but is otherwise ignored when thinking about fiscal policy.

In the era of quantitative easing, that accounting warrants a second look. The Fed now owns $2 trillion in Treasury bonds and $1.5 trillion in other financial assets. Those assets, and the way the Fed finances them, could have significant budget implications.

To understand them, we’ve calculated what the federal government’s debt and financial asset positions look like when you combine the regular government with the Federal Reserve, taking care to net out the debt owned by the Fed and Treasury cash deposited at the Fed:

This consolidated view offers five insights about America’s debt situation:

1. Less long-term debt. The Fed has bought $2 trillion of Treasury debt with maturities of a year or more. As a result, $2 trillion of medium- and long-term public debt is not, in fact, held by the real public. Interest payments continue, but they cycle from the Treasury to the Fed and then back again when the Fed remits its profits to Treasury. (This debt would become fully public again if the Fed ever decides to sell or allows the debt to mature without replacing it.)

2. More short-term debt. The Fed needs resources to buy longer-term Treasuries, mortgage-backed securities, and other financial assets. In the early days of the crisis response, it did so by selling the short-term Treasuries it owned. But those eventually ran out. So the Fed began financing its purchases by creating new bank reserves. Those reserves now account for $2 trillion of the Fed’s $2.3 trillion in short-term borrowing, on which it currently pays 0.25 percent interest.

3. Slightly more overall debt. The official public debt currently stands at $11.9 trillion. When we add in the Fed, that figure rises to $12.1 trillion. Bank reserves and other short-term Fed borrowings more than offset the Fed’s portfolio of Treasury bonds.

4. Lots more financial assets. Treasury’s financial assets now total $1.1 trillion. That figure more than doubles to $2.5 trillion when we add in the Fed’s mortgage-backed securities and other financial assets.

5. Less debt net of financial assets. The Fed adds more in financial assets than in government debt, so the debt net of financial assets falls from $10.8 trillion to $9.6 trillion. That $1.2 trillion difference reflects the power of the printing press. As America’s monetary authority, the Fed has issued $1.2 trillion in circulating currency to help finance its portfolio. That currency is technically a government liability, but it bears no interest and imposes no fiscal burden.

The Fed thus strengthens the government’s net financial position, but increases the fiscal risk of future increases in interest rates. When the Fed buys Treasuries, for example, it replaces long-term debts with very short-term ones, bank deposits. That’s been a profitable trade in recent years, with short-term interest rates near zero. But it means federal coffers will be more exposed to future hikes in short-term interest rates, if and when they occur.

This post was coauthored by Hillel Kipnis, who is interning at the Urban Institute this summer. Earlier posts in this series include: Uncle Sam’s Growing Investment Portfolio and Uncle Sam’s Trillion-Dollar Portfolio Partly Offsets the Public Debt.

Sources: Monthly Statement of Public Debt, Federal Reserve’s Financial Accounts of the United States, and Federal Reserve’s Factors Affecting Reserve Balances.

Playing Favorites in the Corporate Tax Code

The President’s new Framework for Business Tax Reform is two documents in one. The first diagnoses the many flaws in America’s business tax system, and the second offers a framework for fixing them.

Much of the resulting commentary has focused on the policy recommendations. But I’d like to give a shout out to the diagnosis. The White House and Treasury have done an outstanding job of documenting the problems in our business tax system.

As the Framework notes, our corporate tax system pairs a high statutory tax rate with numerous tax subsidies, loopholes, and tax planning opportunities. Our 39.2 percent corporate tax rate (including state and local taxes) is the second-highest in the developed world, and will take over the lead in April when Japan cuts its rate. But our tax breaks are more generous than the norm.

That leaves us with the worst possible system – one that maximizes the degree to which corporate managers have to worry about taxes when making business decisions but limits the revenue that the government actually collects. It’s a great system for tax lawyers, accountants, and creative financial engineers, and a lousy system for business leaders and ordinary Americans. Far better would be to fill in the Swiss cheese of the tax base and move to a lower statutory rate, just as the President proposes (albeit with much more clarity about the rate-cutting than the cheese-filling and with proposals that would make some of the holes bigger).

A related problem is that our corporate tax system plays favorites among different businesses and activities, often with no good reason. To illustrate, Treasury’s Office of Tax Analysis calculated the average tax rates faced by corporations in different industries. As you can see, the corporate tax really tilts the playing field:

I am at a loss to understand why the tax system should favor utilities, mining (which includes energy extraction), and leasing, while hitting services, construction, and wholesale and retail trade so hard. Why should the average retailer pay 31%, while the average utility pays only 14%?

These disparities are unfair and economically costly. Investors recognize these differences and allocate their capital accordingly. More capital flows to industries on the left side of the chart and less to those on the right. Far better would be a system in which investors deployed their capital based on economic fundamentals, not the distortions of the tax system.

The chart highlights one of the key battlegrounds in corporate tax reform. Leveling the playing field (while maintaining revenues) will require that some companies pay more so others can pay less. The U.S. Chamber of Commerce announced Wednesday that it “will be forced to vigorously oppose pay-fors that pit one industry against another.” But such pitting is exactly what will be necessary to enact comprehensive corporate tax reform.

P.S. The full names of the sector names I abbreviated in the chart are: Transportation and Warehousing; Agriculture, Forestry, Fishing, and Hunting; Finance and Holding Companies; and Wholesale and Retail Trade.

How Will Quantitative Tightening Work?

The Fed’s second round of quantitative easing ended in late June. That means we are now in a period of quantitative accommodation. The Fed continues to hold a hefty portfolio of mortgage-backed securities and longer-term Treasuries — thus providing continued, unconventional monetary stimulus — but it’s not adding more.

At the FOMC’s June 21-22 meeting, the members discussed how it would someday exit from this unusual policy posture. In short, the Fed discussed the roadmap for quantitative tightening.

Here’s how it will work:

To begin the process of policy normalization, the Committee will likely first cease reinvesting some or all payments of principal on the securities holdings in the [System Open Market Account].

At the same time or sometime thereafter, the Committee will modify its forward guidance on the path of the federal funds rate and will initiate temporary reserve-draining operations aimed at supporting the implementation of increases in the federal funds rate when appropriate.

When economic conditions warrant, the Committee’s next step in the process of policy normalization will be to begin raising its target for the federal funds rate, and from that point on, changing the level or range of the federal funds rate target will be the primary means of adjusting the stance of monetary policy. During the normalization process, adjustments to the interest rate on excess reserves and to the level of reserves in the banking system will be used to bring the funds rate toward its target.

Sales of agency securities from the SOMA will likely commence sometime after the first increase in the target for the federal funds rate. The timing and pace of sales will be communicated to the public in advance; that pace is anticipated to be relatively gradual and steady, but it could be adjusted up or down in response to material changes in the economic outlook or financial conditions.

Once sales begin, the pace of sales is expected to be aimed at eliminating the SOMA’s holdings of agency securities over a period of three to five years, thereby minimizing the extent to which the SOMA portfolio might affect the allocation of credit across sectors of the economy. Sales at this pace would be expected to normalize the size of the SOMA securities portfolio over a period of two to three years. In particular, the size of the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.

Bottom line: (1) stop reinvesting principal on securities (both MBS and Treasuries, presumably), (2) modify guidance about federal funds rate, (3) raise federal funds rate (and interest on reserves), (4) sell agency securities. If I am reading this correctly, selling Treasuries is not part of the exit strategy. The Fed’s Treasury portfolio will thus decline soley as principal payments are made.

If QE2 Is Over, Does That Mean QA2 Just Started?

Everyone has been writing epitaphs for the “end” of QE2, the Federal Reserve’s program to buy $600 billion in Treasury bonds.

In a narrow sense, they are right: the Fed just completed those purchases. What most coverage misses, however, is that the effects of “quantitive easing” depend at least as much on the Fed’s owning the bonds as buying them. The stock matters at least as much as the flow.*

The epitaphs apply only to the buying. The stock–Fed ownership of $600 billion in Treasury bonds–is still with us.

Which brings us to today’s question: What should we call that? To say that QE2 is over leaves the impression that the program is over. It’s not.

One answer would be to expand the definition of QE2 to include the owning as well as the buying. In that case, we’d simply say that QE2 is still in place.

That strikes me as the cleanest solution except for one thing: almost everyone seems to want to believe that QE2 is over. So we need a new name.

To get some inspiration, consider the three stages of traditional monetary policy. You know, the kind where the Federal Reserve moves short-term interest rates up and down:

Cutting rates (easing)
Keeping rates low (accommodation)
Raising rates (tightening)

The Fed’s asset purchases will go through three stages as well:

Buying assets (quantitative easing)
Owning assets (quantitative accommodation)
Selling assets (quantitative tightening)

Stage 1, quantitative easing, just ended. When the Fed someday starts selling, that will clearly be quantitative tightening.

But what about stage 2? The best I can come up with is quantitative accommodation, QA for short.

That doesn’t really flow off the tongue, and better suggestions would be welcome.

For now, though, here’s my recommendation: If you insist on saying that QE2 is over, you should also be saying that QA2 just began.

* For example, here’s Chairman Bernanke discussing stocks and flows at his inaugural press conferencein April:

[W]e subscribe generally to what we call here the stock view of the effects of securities purchases, which—by which I mean that what matters primarily for interest rates, stock prices, and so on is not the pace of ongoing purchase, but rather the size of the portfolio that the Federal Reserve holds. And so, when we complete the program, as you noted, we are going to continue to reinvest maturing securities, both Treasuries and MBS, and so the amount of securities that we hold will remain approximately constant. Therefore, we shouldn’t expect any major effect of that. Put another way, the amount of ease, monetary policy easing, should essentially remain constant going forward from—from June.

Playing with Fire with the Debt Limit

My latest column in the Christian Science Monitor:

America sometimes takes its exceptionalism too far.

Case in point: We are the only major economy that talks openly of default.

Government debt has ballooned throughout the developed world in the aftermath of the Great Recession. France and Britain are as deep in debt as the United States, for example, and Japan is much further in the hole.

But their leaders never mention the possibility of default. Why would they? If you have the ability to pay your bills, there’s no reason to scare your creditors.

But that’s exactly what we do in America. Treasury Secretary Timothy Geithner has been warning about the risks of default since January.

If we don’t increase the debt limit by early August, he tells us, default becomes a real possibility. And that could pose grievous risks to our already weak economy.

Many Republicans play down that risk. Echoing famed investor Stanley Druckenmiller, some argue that a temporary default would be acceptable if it’s part of a larger political strategy that brings future deficits under control.

But that is a dangerous game.

Large swaths of America’s financial infrastructure have been built on the assumption that US Treasuries pay on time. And financial markets would likely punish the US with higher interest rates if we defaulted. That’s what happened in 1979, for example, when back office snafus caused Treasury to unintentionally miss payments to some investors.

This time, Fitch, Moody’s, and Standard & Poors are threatening to cut the US credit rating if we choose to default. Given the risks, most observers recognize that default is not, and should not be, an option. The US is not a deadbeat nation.

But does that mean the debt limit has to go up in early August? Some Republicans say no because of a simple fact: Every month, the federal government collects more in taxes than it pays in interest. With careful cash management (which would likely have to start before the August deadline), Mr. Geithner should be able to prioritize debt payments and thus avoid debt default.

As best as I can tell, that argument is correct, but it’s hardly a reason for complacency. America is currently spending about $100 billion more each month than it collects in revenues. If we hit the debt limit, we won’t be able to pay everyone who is rightly expecting to be paid.

Geithner can and should ensure that our debtholders get paid.

But someone – perhaps millions of someones – won’t be paid on time. Contractors, federal workers, program beneficiaries, or state and local governments will suddenly find themselves short on their cash flow.

That won’t be good for the economy. Even though it’s not as bad as debt default, it still would paint the US as a deadbeat.

The US faces severe fiscal challenges in the years ahead. It’s perfectly reasonable that lawmakers want to combine an increase in the debt limit with efforts to rein in future deficits.

But that worthy goal should not weaken our commitment to paying – on time and in full – the obligations that we have already incurred.

As the debt limit draws near, our leaders should stop playing with fire and craft instead a plan to rein in future deficits without threatening our struggling recovery.

That’s a difficult balancing act, requiring tough compromises across the political spectrum. But as everybody knows on Capitol Hill and beyond, it would be the best step for the nation and our fragile economy.

It would also be exceptional.

The Day the United States Defaulted on Treasury Bills

In October 2013, a slightly updated version of this post appeared here.

Since the day of Alexander Hamilton, the United States has never defaulted on the federal debt.

That’s what we budget-watchers always say. It’s a great talking point. One that helps bolster the argument that default should not be an option in Washington’s ongoing debt limit slowdown.

There’s just one teensy problem: it isn’t true. As Jason Zweig of the Wall Street Journal recently noted, the United States defaulted on some Treasury bills in 1979. And it paid a steep price for stiffing bondholders.

Terry Zivney and Richard Marcus describe the default in The Financial Review (sorry, I can’t find an ungated version):

Investors in T-bills maturing April 26, 1979 were told that the U.S. Treasury could not make its payments on maturing securities to individual investors. The Treasury was also late in redeeming T-bills which become due on May 3 and May 10, 1979. The Treasury blamed this delay on an unprecedented volume of participation by small investors, on failure of Congress to act in a timely fashion on the debt ceiling legislation in April, and on an unanticipated failure of word processing equipment used to prepare check schedules.

The United States thus defaulted because Treasury’s back office was on the fritz.

This default was, of course, temporary. Treasury did pay these T-bills after a short delay. But it balked at paying additional interest to cover the period of delay. According to Zivney and Marcus, it required both legal arm twisting and new legislation before Treasury made all investors whole for that additional interest.

Some may quibble about whether this constitutes default. After all, the United States did eventually make its payments. And the disruption applied to only a sliver of its debt – certain T-bills owned by individual investors.

But I think it’s unambiguous. A debt default occurs anytime a creditor fails to make a timely interest or principal payment. By that standard, the United States did default. It was small. It was unintentional. But it was indeed a default.

And the nation still stands. But that hardly means we should run the experiment again and at larger scale. Zivney and Marcus examined what happened to T-bill interest rates as a result of this small, temporary default. They find a surprisingly large effect. As best they can tell, T-bill interest rates increased about 60 basis points after the first default and remained elevated for at least several months thereafter. A simple way to see that is to look at daily changes in T-bill yields:

T-bill rates spiked upwards four times in the months around the default. In November 1978, Henry “Dr. Doom” Kaufman predicted that interest rates would rise. They did. Turn-of-the-year cash management caused rates to fall and then rise as 1978 became 1979. And rates spiked and fell in October 1979 when Paul Volcker announced that the Fed would target monetary aggregates rather than interest rates (the “Saturday night special”).

The fourth big move was the day of the first default, when T-bill rates rose almost 0.6 percentage points (i.e., 60 basis points).There’s no indication this increase reversed in the days that followed (the vertical line on the chart is just a marker for the day of default). Indeed, using more sophisticated means, including comparing T-bill rates to interest on commercial paper, the authors conclude that default led to a persistent increase in T-bill rates and, therefore, higher borrowing costs for the federal government.

The financial world has changed dramatically in the intervening decades. T-bill rates hover near zero compared to the 9-10 percent range of the late 1970s; that means a temporary delay in payments would be less costly for creditors. Treasury’s IT systems are, one hopes, more reliable that 1970s vintage word processors. And one should take care not to make too much of a single data point.

But it’s the only data point we have on a U.S. default. Not surprisingly it shows that even temporary default is a bad idea.

P.S. Some observers believe the United States also defaulted in 1933 when it abrogated the gold clause. The United States made its payments on time in dollars, but eliminated the option to take payment in gold. For a quick overview of this and related issues, see this blog post by Catherine Rampell at the New York Times and the associated comments.

Treasury Takes Step 1 in Avoiding the Debt Ceiling

As expected, Treasury has announced that it will allow the $200 billion Supplemental Financing Program to run down to only $5 billion; that will save $195 billion of borrowing authority under the current debt ceiling:

Treasury Issues Debt Management Guidance on the Supplementary Financing Program
1/27/2011
WASHINGTON – The U.S. Department of the Treasury’s Assistant Secretary for Financial Markets, Mary Miller, today issued the following statement on the Supplementary Financing Program:
“Beginning on February 3, 2011, the balance in the Treasury’s Supplementary Financing Account will gradually decrease to $5 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over. This action is being taken to preserve flexibility in the conduct of debt management policy.”

Treasury created the SFP in order to help the Fed expand its balance sheet without “printing money” (or, more accurately, “printing reserves”). Under the program, Treasury issues bonds, as usual, but it deposits the proceeds in an account at the Federal Reserve, rather than using them to pay the nation’s bills. The Fed then uses those deposits to purchase assets. Since the money ultimately comes from investors who own the new Treasury bonds, the SFP allows the Fed to expand its balance sheet without creating reserves out of thin air.

With the program winding down — at least until the debt ceiling gets raised — the Fed will have to ask its electronic printing press for another $195 billion if it wants to maintain its targeted portfolio.