Is the Fed monetising the deficit? - Capital Economics
US Economics

Is the Fed monetising the deficit?

US Economics Update
Written by Paul Ashworth

The scale of the Fed’s purchases of Treasury securities in the first few weeks of the pandemic, in addition to the sheer size of the broader expansion in its balance sheet, arguably suggests that the Fed is not just monetising the deficit, but has unleashed a full-blown helicopter money drop. As the crisis develops over the next few months, however, we suspect the Fed will continue to reduce the pace of its Treasury securities purchases, while the fixed-term loans it is making to the private sector do not represent a permanent increase in the money supply, which is the distinguishing feature of helicopter money.

  • The scale of the Fed’s purchases of Treasury securities in the first few weeks of the pandemic, in addition to the sheer size of the broader expansion in its balance sheet, arguably suggests that the Fed is not just monetising the deficit, but has unleashed a full-blown helicopter money drop. As the crisis develops over the next few months, however, we suspect the Fed will continue to reduce the pace of its Treasury securities purchases, while the fixed-term loans it is making to the private sector do not represent a permanent increase in the money supply, which is the distinguishing feature of helicopter money.
  • Monetary financing of the budget deficit and helicopter money are related concepts but differ in several important ways. In a debt monetisation, the central bank absorbs the government’s net bond issuance by expanding its own balance sheet – either buying the debt in the secondary market or even directly from the fiscal authorities. The resulting increase in the monetary base is not necessarily permanent, however, since the central bank could opt to run down its balance sheet in the future – either by selling those assets again or not buying more debt with the returned principal when the bonds mature.
  • The distinguishing feature of a helicopter money drop is that the associated increase in the monetary base is permanent. That distinction is important because it makes it more likely the monetary base expansion will eventually trigger a corresponding rise in broad money and consequently, when the economy’s resources are fully utilised again, the prices of goods and services too. We normally think about helicopter money in terms of the central bank giving the newly printed money to the fiscal authorities to spend, but it could always cut out the middle man and transfer the money directly to households or businesses.
  • The Fed’s purchases of Treasury securities over the past few weeks already dwarf the size of its earlier QE programs, which each ran for more than 12 months. Over the past month, its balance sheet has expanded from $4trn to $6trn, as its holdings of Treasury securities increased by more than $1,000bn. The Fed’s purchases over the past 12 months now easily exceed the Federal budget deficit, which was $865bn. (See Chart 1.) In other words, the Fed has absorbed all of the net issuance of Federal debt, which is more than it did during QE1 or QE2. Even during QE3, the Fed’s purchases only just exceeded the budget deficit for a few months.
  • Although the Fed appears to be monetising all of the deficit, the situation is a little more nuanced. First, the budget figures for March don’t yet reflect the coming surge in the deficit, as the $2.3trn CARES Act is implemented. The Federal deficit – and the associated net Treasury debt issuance – will climb to more than $2trn over the next year. Second, even after its recent super-charged buying of Treasury securities, the Fed’s holdings still account for slightly less than 20% of the total held by the public, which is equivalent to the post-GFC share, not that much higher than the pre-GFC share, and well below the post-war peak of more than 25% reached in the early 1970s. (See Chart 2.) That said, its holdings are at a record high relative to GDP.

Chart 1: Budget Deficit & Fed’s Treasury Holdings ($bn)

Chart 2: Fed’s Treasury Holdings

Sources: Refinitiv, Federal Reserve

  • Furthermore, the reasoning behind the Fed’s purchases over the past few weeks is completely different to its goals that shaped the earlier three rounds of QE. In this case, the Fed has been trying to inject liquidity into the Treasury market, by buying securities across the curve, whereas QE was designed to lower long-term interest rates, by concentrating on purchases of longer-dated Treasury securities. (Structural changes mean that the Treasury market is no longer anywhere near as deep and as liquid as it was a decade ago.)
  • The Fed’s motivation matters because that will determine how its purchases evolve. With the reduction in bid/ask spreads indicating that strains in the Treasury market are easing, the Fed has already reduced its purchases from a peak of $75bn per day in the third week of March to a planned $15bn per day this week. Unlike a few years ago, the ultra-low level of long-term yields means that there is little reason for the Fed to engage in traditional QE/ credit easing by retooling its asset purchases to focus on the long end of the curve. The upshot is that within another couple of months we think the Fed could return to buying only $60bn of short-term Treasury bills each month. The Fed may have bought all the net Treasury issuance in the past 12 months, but it will end up buying only a small fraction of the much bigger issuance over the next 12 months.
  • As phase one of the Fed’s response to the crisis is beginning to wind down, it is about to launch phase two which, rather than buying government debt, will commit up to $2.3trn to support non-financial businesses, households and State & local governments. Using nearly $200bn of the Treasury’s money to cover potential losses, the Fed is going to launch a $600bn Main Street Lending Program to provide loans to smaller businesses via commercial banks, devote $850bn to buying corporate bond debt, including newly issued debt and high yield debt, and provide up to $500bn in liquidity for State and local governments. The Fed will also buy Paycheck Protection Program loans made by commercial banks and backed by the Federal government. $350bn of loans have already been approved under that program and, as a result of its popularity, Congress is discussing raising the overall size to more than $600bn. Since the CARES Act set aside $450bn for the Treasury to back the Fed’s lending, the latter could also at some point expand the overall size of its facilities for the private non-financial sectors to nearer $4trn.
  • That phase two lending by the Fed to the non-financial private sector under those various programs doesn’t qualify as monetary financing of the Federal budget deficit and, since the fixed-term loans will last between two years (the paycheck protection loans) and four years (the Main Street loans), it appears to be less of a permanent increase in the monetary base than when the Fed was focused on buying long-dated Treasury bonds, which might not mature for a decade or more. The bottom line is that the phase two expansion of the Fed’s balance sheet looks less like an attempt to monetise the deficit or a helicopter money drop than its earlier QE programs.
  • Nevertheless, although the next phase of the Fed’s balance sheet expansion may not meet the strict definitions of public debt monetisation or helicopter money, not everything is quite as black and white as that. First, the Fed will now be facing several monetary cliffs over the next few years. Without offsetting action, its balance sheet would shrink again when the loans to the financial and non-financial sectors are re-paid. In four years’ time, when the Main Street loans are due to be repaid, we doubt the Fed – which likes to act in a gradual and well-telegraphed way – will want its balance sheet to shrink by $600bn in a matter of a couple of months. The obvious way to prevent that would be to start buying more Treasury securities again.
  • Second, the Fed has sailed so far into unchartered waters, in terms of the size and pace of the expansion in its balance sheet and the lower quality of the private assets it is buying that if it is willing to do all that, why would it draw the line at monetising the deficit? After all, setting up those facilities has meant working ever closer in partnership with the Treasury and its Secretary Steven Mnuchin. At this stage, debt monetisation and even helicopter money are just another step down the road. Moreover, after a decade of under-shooting the target, we had already seen the Fed relax its guard as far as the dangers of higher inflation were concerned. This crisis may be a reason to abandon its 40-year inflation battle entirely.

Paul Ashworth, Chief US Economist, paul.ashworth@capitaleconomics.com