The Wall Street Journal reports Wednesday that the Fed is considering issuing its own debt for the first time. Why? Wee, because it would give the central bank additional flexibility as it tries to stabilise rocky financial markets, of course. The paper explainsFed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter. It isn’t known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn’t explicitly permit the Fed to issue notes beyond currency. Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.
At the core of the deliberations is the Fed’s balance sheet, which has grown from less than $900 billion to more than $2 trillion since August as it backstops new markets like commercial paper, money-market funds, mortgage-backed securities and ailing companies such as American International Group Inc. The ballooning balance sheet is presenting complications for the Fed. In the early stages of the crisis, officials funded their programs by drawing down on holdings of Treasury bonds, using the proceeds to finance new programs. Officials don’t want that stockpile to get too low. It now is about $476 billion, with some of that amount already tied up in other programs. The Fed also has turned to the Treasury Department for cash. Treasury has issued debt, leaving the proceeds on deposit with the Fed for the central bank to use as it chose.
But the Treasury said in November it was scaling back that effort. The Treasury is undertaking its own massive borrowing program and faces legal limits on how much it can borrow. More recently, the Fed has funded programs by flooding the financial system with money it created itself — known in central-banking circles as bank reserves — and has used the money to make loans and purchase assets. Some economists worry about the consequences of this approach. Fed officials could find it challenging to remove the cash from the system once markets stabilize and the economy improves.
It’s not a problem now, but if they’re too slow to act later it can cause inflation. Moreover, the flood of additional cash makes it harder for Fed officials to maintain interest rates at their desired level. The fed-funds rate, an overnight borrowing rate between banks, has fallen consistently below the Fed’s 1% target. It is expected to reduce that target next week. Louis Crandall, an economist with Wrightson ICAP LLC, a Wall Street money-market broker, says the Fed’s interventions also have the potential to clog up the balance sheets of banks, its main intermediaries. “Finding alternative funding vehicles that bypass the banking system would be a more effective way to support the U.S. credit system,” he says.
It seems this would be the Fed’s attempt to offset some of the money created out of thin air as part of its quantitative easing programme. An attempt at re-sterilisation. But there are some major issues to overcome. Not only would the Fed be competing with the Treasury for sales, it would also be creating a very confusing precedent.
All that said, if the Fed decided to issue the debt in a foreign currency - the precedent exists with Carter bonds - it might actually offer some interesting incentives to foreign investors. It would also allow the Fed to indirectly backstop the dollar, or at least curb its massive devaluation. Issuing foreign currency-denominated Treasury-style debt could also reduce the perceived risk of holding US debt, increasingly important as CDS spreads widen and Treasury yields go negative.
Related Links:
Fed ponders issuing debt to financing its mushrooming balance sheet - Naked Capitalism
US 3-mth yields go negative - FT Alphaville
Obama bonds - the new T-bills? - FT Alphaville
